Money Talk

Episode 54

The Perfect Value Investor



Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with hosts Ed Sutkowski and Chuck LeFebvre. Let’s listen in.

Chuck: Welcome to Money Talk. This is Chuck.

Ed: I’m Ed, and today’s topic is the perfect value investor as if there is such an animal.

Chuck: Yes. Is this an investor seeking perfect value, or is this a perfect investor who does value investing?

Ed: I think it addresses the psychology. In other words, my view of the world, which I’m confident is incorrect, is that investing should be a long-term exercise, and it’s more psychological than it is quantitative. In other words, the quants that you have behind the closed doors of all these big investment houses are doing all these projections. I think it’s, I wouldn’t want to say silly, but I’m not sure that you can predict what’s going to happen in the stock market for more than two days. I don’t know what you’re–

Chuck: Well, I’d go even one step further, and I would say even after something has happened with the stock market, people are, to a large extent, guessing when they think about why that thing happened. You’ll see news report that says, “Stocks were up today on news of X, Y, Z.” Well, how do you know that X, Y, Z is the reason why the stocks went up? Sometimes it’s obvious. A war starts or something like that happens, and that clearly has an impact on the stock market, but quite often, they’re simply guessing that the market is reacting to something.

Ed: The black swan.

Chuck: Yes, exactly. It’s trying to match up two events that correlate into a story about causation that may or may not be true.

Ed: I think it’s an attempt, if you said X, you’ll get the facts that support X. You’re justifying your existence, I think.

Chuck: Right. Yes. I emphatically agree with your opening comment that really the only successful way to invest is with a long-term outlook because even though it is a difficult, if not impossible task to make a short-term prediction about what’s going to happen with any particular market, the stock market in particular. You can make accurate and reliable predictions about what happens over the long term, and so that should be your investment horizon.

Ed: Exactly, right. I support that more than you would expect me to say.

Chuck: I’m proud of myself for articulating.

Ed: Yes, Chuck–

Chuck: I’ve been thinking that for many years and never really put it together in words.

Ed: I will tell you, to support what you’re suggesting, I have one security that I’ve owned for 46 years.

Chuck: Yes. Maybe this will be the year it takes off.   I know which one you’re talking about. It’s done pretty well.

Ed: Yes, I bought those when I was four years old.

Chuck: Exactly.

Ed: No, but the point is, we’re engaging in a discussion that isn’t subscribed to by almost anyone in the world that is in this business.

Chuck: Right.

Ed:  My view is that, this is all psychological, and if you’re going to make money, it requires deferral of self-gratification.

Chuck: Very much.

Ed: Keep your old car, don’t buy a Tesla. It involves some discipline, and it involves math, but not in the math that was required 20 years ago because today, you have access to all this information on the internet.

Chuck: Right. I would even push back on whether it really involves math. It involves, not being afraid of numbers, but really, you don’t have to do much calculating on your own these days. You do have to be able to look at metrics that are readily available and make sense out of them. That I think is true, but even at that, we’re really talking about a relatively small set of metrics. I think.

Ed: Yes. The two I subscribe to. First, forget the noise, forget what’s subscribed, and you can see TV, and all these experts telling you what to do, and everyone in the world tells you what stocks to buy. I get three or four emails unsolicited a day. I always want to ask those people, “Let’s see your balance sheet.” Of course, it’s not relevant. I had that happen with a quoted investment advisor in Chicago, who was telling me all these things had to be done for this client. I said, “Why don’t you tell me how you’ve done?” “Oh, it’s not relevant. It’s not relevant.” Okay, it’s not relevant.

Chuck: Right.

Ed:  Well, the metrics that I focus on, almost exclusively, are two: the dividends and the return on investment capital.

Chuck: Yes .

Ed:  I look at those two, and you can almost forget about everything else. Specifically, the last time we went through this with my trading assistant, Home Depot’s return on equity is 1,001,465.50. That’s Home Depot. Apple’s 175.46%.

Chuck: Percentage points.

Ed: Wait a minute, that’s almost crazy. The stock may be high or low, but if you hold that stock for any period of time or any stock that has a good return on invested capital and good dividends, what’s going on with the world here?

Chuck: Right. Right, but you’re focusing on not just return on invested capital, return on equity, right?

Ed: Yes, I should have said equity.

Chuck: That is a really direct metric of what it is. It’s essentially the total return for the equity investor, which is what you are when you’re buying stock.

Ed: That’s right. I’ll give you a million dollars, Chuck, and I have a base– I expect if I’ve had this in a safe investment, I’d get maybe 2%, 3%. I’m going to share the upside with you. 80-20, I get 80, you get 20. What I’m focusing on is the return on that investment. Putting it another way, the number I gave you is the return on equity, which is the excess of assets over liabilities.

Chuck: Right.

Ed: But the idea of focusing on everything else, I think, is silly.

Chuck: Right.

Ed:  The perfect value investor has some attributes that are pretty good guidelines, highly concentrated portfolios.

Chuck: Yes, that is the anathema to modern portfolio theory, which may be the reason why you and I are always running into friction with investment gurus and investment advisors because they’re constantly preaching the religion of wide diversification, which of course, wide diversification will result in reduced risk for the investor. That’s what a professional advisor is always looking for, is that if something goes south, they want to be able to say, “Well, look, it’s not because I’ve made bad choices for you, it’s because the entire market went south. Don’t look at me.”

Early in my years involved in this field, I had someone sit me down and say, “Chuck, all that stuff about diversification is absolutely true,” but what I’ve noticed is that the people who really make money with investing, don’t do that. They have concentrated portfolios, and that’s absolutely the case. The question is, can an individual investor, who’s not doing this full-time have a concentrated portfolio, and still do that without incurring a great deal of risk? By risk, I mean, the risk of essentially losing everything.

I think when you talk about highly concentrated portfolios, I know the way you do this, there’s still a big chunk of a particular portfolio that’s in, for instance, in index ETF. You’re talking about– that’s kind of your base, but then you’ve got some individual investments you’re making on top of that, which are concentrated.

Ed: Yes, my view is, my spouse doesn’t have a canary and my family thinks, “Oh, he’s going to throw away all this inheritance.” I seek 80% 3, or 4, or 5 stocks. 20% in index funds, EFTs, or whatever. I’d frankly like to get rid of those but because of these constraints, I don’t.

Chuck: Right.

Ed:  I should also tell you that the difference is not only of that 80-20, is that I have a high degree of margin.

Chuck: Let me stop you because when you say 80%-

Ed: In five stocks.

Chuck: -in five stocks, it’s really less than 20% in any one stock. I just want to make sure that people listening understand when you say highly concentrated portfolio, you’re not talking about 80% in one stock.

Ed: No.

Chuck: You’re talking about– there’s some that’s in an ETF and then you’ve put 20% or less in any 1 of 5 stocks or so.

Ed: Make sure that’s cost. That’s not fair market value. I don’t rebalance, the other traditional, “You got to rebalance at the end of the year. It’s your 80%,” and depending upon your age if you’re 80 years old, you should have 80% in fixed, and 20% in equity. All those noise things, I disregard.

Chuck: Right.

Ed:  Because when I first started this game a couple of years ago, none of this information was available.

Chuck: Right.

Ed:  You read Graham and Dodd and The Intelligent Investor and what made sense. If you sit back and think what makes sense where you buy good stocks, good return on equity, and dividends, and leave it alone.

The real good investors, the pros that do this, and I’m a rookie. I have this day job that seems to be consumptive, but I’m willing to hold the stocks for a long period of time. 46 years, that’s a long period of time.

Chuck: Right.

Ed:  Why? Because I think it’s a good stock. The issue I always face is, “Okay, I want to sell that stock. Now, what do I buy?

Chuck: Right.

Ed:  What’s better?

Chuck: Right. I think that when you buy a stock, I’ll hear people say, “I’m going to buy this stock because I think sometime in the next year or so, X, Y, Z is going to happen.” I think that’s a good reason. If that’s your reasoning when you’re going to buy a stock, you probably shouldn’t buy it because what you should be looking at is, is this a stock that I’m prepared to own for the rest of my life? It doesn’t mean you will. It just means that the decision to buy it needs to be based on something you see there that you have no reason to believe has an expiration date.

Ed: That doesn’t mean you say, “You got to look at it.” I look at this more often than I should just to validate and read some of the publications on those stocks. Not everything else in the world. I’m willing to accept a down year.

Chuck: You have to.

Ed: That is going to happen and there’s no way that you can dissuade me to thinking that isn’t going to happen. It happens.

Chuck: Now, when you say that, are you referring to a down year for a particular stock company? Now, obviously, the market as a whole can have a down year, and there’s no reason to react to that, but with an individual stock, if it goes down, or if it performs poorly, you do have to look at it and ask yourself, is this part of a permanent trend or is this just something that happened?

Ed: Yes. I want to respond to that in a different fashion. Those 4 or 5 stocks did not have a 20% decline last year.

Chuck: Yes, they were chosen correctly.

Ed: The point is, there are long-term investments, good, concentrated  position in their market.

Chuck: Right.

Ed:  For example, Apple is dominant.

Chuck: Right.

Ed:  Home Depot is dominant. I’m just saying those two, and I’m not recommending anyone buy either of those.

Chuck: Right.

Ed:  But I’m saying I get to the dominant player in that market, buy and hold.

Chuck: Right.

Ed:  I didn’t experience a 19% downturn.

Chuck: Right. Well, part t of what you’re looking at as you dig in deep to something is you’re looking at how it’s performed over an entire business cycle, at least, right?

Ed: Yes, multiple cycles.

Chuck: Right. You have a good sense of the next time there’s a recession, there’s always going to be some other recession in the future, how does this particular company perform during those times? If it’s highly cyclical stock, you would expect that it would react a little bit more than one that’s not. You’ve mentioned Home Depot a couple of times. That is an example of the stock that you expect to have react to the business cycle to a certain extent and yet you can see looking at what’s happened in the past, to what degree it’s been resilient.

Ed: I think of personalities in, although Warren Buffett, I’m not suggesting that., I’m anything like this guy who was at the top of the bottle, but he said the secret of successful investing is compound interest and living long.

Chuck: Yes.

Ed:  I hate to say that but if you have that principle involved, living long and compound interest, and don’t have all scanner shots of 50,000 issues, 250 issues, you’re going to be fine.

Chuck: Right. Right.

Ed:  If you’re wrong on some of the stocks you’re proposing, then get rid of the losers.

Chuck: Right.

Ed:  Sell the losers and keep the winners. People don’t like to do that.

Chuck: Right.

Ed:   This loss aversion, “Ah, you got to be willing to take a loss.” “Okay, fine.” I have had so many losses; I can’t count them.

Chuck: Right.

Ed:  Why do I look at the losses and why did I do that? I’ll probably do it again. I’m a bit of a blockhead when it comes to investing. Common sense, buy good stocks, buy and hold. If you’re not equipped to handle margin, don’t handle margin.

Chuck: Right.

Ed:   But my powerful incentive is, I like to borrow the money to see how I can do and make sure–

Chuck: Right. You follow the 80-20 rule there too, right?

Ed: Yes. Although I typically violate the 20%. The point is, if someone’s a damn fool to loan the money to me, I’ll borrow. I’ll borrow the money and I’ll pay them back.

Chuck: Right.

Ed:  M ake sure there’s enough life insurance to cover the debt and don’t tell the family because they’ll all have canaries.

Chuck: Right.

Ed:  The point is, this is a different approach and that should be clear to the listeners. This is not something everyone or for that matter, anyone should do. But the point is, there’s different ways of skinning this proverbial cat.

Chuck: Yes .

Ed:  What are you comfortable with?

Chuck: That actually reminds me, go back to this idea of ignoring the noise. What do you mean when you say noise? I have my own sense of what that means but–

Ed: When channel surfing trying to find a football game I’ll want to watch. You’ll see this Cramer. What’s his first name? I don’t know.

Chuck: Jim Cramer.

Ed: Yelling and screaming about this stock. And Eli Lilly is going to have obesity. Oh my gosh.

Chuck: Right.

Ed:  Just drive me nuts.

Chuck: Right. You’re talking about all the chatter about what particular companies are doing and this and that.

Ed: Tesla. Wait a second. It rebounded. He’s raising the price. He’s going to, “Oh, I can’t.” This guy Musk is brilliant but I’m sorry I can’t follow him.

Chuck: Right.

Ed:  I don’t need that volatility.

Chuck: I sort of – tell me if I’m misinterpreting this but what I’m hearing is, something like don’t get caught up in these narratives about a particular company. There’s some story that’s supposed to get you excited about a particular– Tesla’s a great example. There’s this story behind it. There’s this charismatic CEO. There’s this trend towards electric vehicles. There’s all this stuff that sweeps you along. You can get emotionally involved in the idea of wanting that company to do well or wanting that CEO to do well. That kind of sweeps you along. That’s noise.

Ed: Never want to visit with a corporate executive. I never want to hear the story because it’s always going to be noise.

Chuck: Right.

Ed:  The greatest thing is in sliced bread.

Chuck: Right.

Ed:  But I don’t listen to people telling me what I should be doing. Consider the source.

Chuck: Right.

Ed:  We’ve talked about this time and time again. What is the nature of the message? And who is expressing it? And what is the skin in the game for those people? There’s usually some reason that you’re being told what to do.

Chuck: Yes.

Ed:   You don’t tell me what to do. You can suggest it and I’ll take a look at it but I’ve got this day job. I think that’s a positive. The other part of that is if you’re a professional investor, you’re there full-time, and seems like you got to make noise, you got to trade. It sounds like you’re doing something. But when if you’re a rookie like yours truly, I’ve got the day job, so I can’t be doing trades back and forth, back and forth.

Chuck: Right.

Ed:  That’s worked for me over the years because I’m not capable of doing two things.

Chuck: Right.

Ed:  Again, the passion, the message is that if you’re trying to accumulate our clients that we’ve run into, Chuck, those that have accumulated substantial amounts of net worth and more than they need but it’s a game. They’re focused on one thing. If it’s manufacturing, that’s manufacturing. If it’s farms, it’s farms. They’ll often have a business to yield cash to buy farms.

Chuck: Right.

Ed:  The point is they’re not Harvard MBAs, they’re not technocrats. They’re human beings that have a powerful focus. Very narrow, but very, very deep.

Chuck: Yes.

Ed:  Do you find that, Chuck?

Chuck: Yes, I definitely found that to be the case with entrepreneurs, small business owners, definitely. They live with that.

Ed: And good investors.

Chuck: Yes.

Ed:   Whether it’s stocks, bonds, real estate, farms, apartment buildings, whatever it is they focus and they know more about that than perhaps anyone else in the room.

Chuck: Right. I  want to go back to separating out what constitutes noise from what constitutes information you want to rely on. You don’t want to hear the story from the CEO, but at the same time, you do want to understand how the company makes money. Right? You see these companies out there where you’re like, well, Twitter’s no longer public, but that’s a good example of one where you would say, “Are they actually making money? How do you make money?”

If you don’t understand how the company’s making money– maybe it is. Maybe it’s a great company, but to me, at least, if I can’t understand what that business model is, then to me, I think, well, I’m not going to just rely on the fact that I like these metrics. I want to understand the business plan here.

Ed: That’s the difference in knowing everything about everything. It’s not possible to know everything about everything, interest rates, international, the whole nine yards. If you can go on and on about things, you should “know about.” No, it’s again, narrow and deep.

Chuck: Yes.

Ed:  Dissuade yourself from turning the TV on. Forget about Cramer. Forget about all the emails you get. Read the Wall Street Journal. It’s the day after the market is closed. You read the Wall Street Journal just to get a sense of what’s going on because it’s old news by the time it’s printed.

Chuck: Right. Right.

Ed:  Noise is a big deal. Passion is a big deal but focus and in knowing full well that you’re going to have a bad year, the sense that stock is going to go down. You don’t have a loss until you sell it,

Chuck: Right.

Ed:  But I don’t know. Chuck, you’ve had some experiments more than I would in your role as a trustee with clients. You always got to deliver them good news?

Chuck: Right. Well, you always have to be able to blame someone else if you have bad news. Right? Which is why in the industry, you hear this big emphasis on diversification because if you buy enough different things with the investment, spread around far enough than if there’s a loss, it’s because the market lost.

Ed: You’re not going to lose the relationship.

Chuck: Right.

Ed:  That’s the critical thing. I can assure you;   I could never be an investment advisor to folks. No, not going to happen because we’ve got bad news, you don’t like it, tough.

Chuck: Right.

Ed:  Then get out of the market. Go ahead and buy annuities or buy I don’t know what.

Chuck: Right.

Ed:  The point is this isn’t for everyone.

Chuck: No, it isn’t.

Ed: What is your risk tolerance and is it fun? Then do it. If it’s not fun–

Chuck: Most people have a lower risk tolerance than you and I do on this. When we talk, we’re always just talking about stocks.

Ed: Yes, because that’s what this country is about.

Chuck: Right.

Ed:  This is capitalism at its best. Giving someone an opportunity to create value, not only quantitative but having people have a job.

Chuck: Yes.

Ed:  Second question people ask you is what? What do you do?

Chuck: Right.

Ed:  So, if you’re creating value permitting people, see, I work for Charlie and we manufacture widgets, and these are changing the world. Bill Gates. Hell, yes. I started in my garage and we got, well, certainly have Microsoft.

Chuck: Right.

Ed:  That’s changing the lives of all kinds of people.

Chuck: Right.

Ed:  Why am I infatuated with the stock market because of that?

Chuck: Right.

Ed: You’re creating opportunities. You’re improving yourself. You’re improving those around you. Our day job relates to taxes. It’s really the minimization or avoidance appropriately of income, management, and transfer taxes. That’s a fun game.

Chuck: It is.

Ed: What could you do that you would have as much fun? Have you ever thought of that?

Chuck: No, I have not.  Well, at least I haven’t come up with an answer.

Ed: Pretend I asked that question. If you weren’t doing what you’re doing now, if someone said, Chuck, you’re done, you can’t do what you’re doing. What would you turn out and do?

Chuck: Wow, Ed. It would be something with a very different pace. You wouldn’t be able to work at this pace and have this much fun. I wouldn’t doing anything else.

Ed: I would–

Chuck: I would have to as compensation for the fact that I wouldn’t be having as much fun, I’d have to slow down significantly.

Ed: When you slow down, we’ve worked with, and unfortunately, I’ve seen a situation, my colleagues have retired. Provisional death as far as I’m–

Chuck: That’s not slowing down.

Ed: The cliff I’m going to– do nothing but play golf, pickleball, tennis. What?

Chuck: Right.

Ed:  What do you read? Read? I don’t read anything. I read the Wall Street Journal and I go to this club to play golf with my bud– no, no, no. You’re doing a bad job handling what someone upstairs gave you.

Chuck: Right, you’re inviting a crisis of identity by making such a sudden shift in what you’re doing on a day-to-day basis.

Ed: I’ll answer the question I asked you and the answer is, I don’t know.  I don’t know when I had more fun. My dad was an artist. Tried painting.

Chuck: You could try.

Ed: He said, “Eddie, here, come here. Let’s show you how to do watercolor.” Everything turned brown. He said that, “Hey, listen. They’re playing football or lacrosse. Why didn’t you go do that.” He never asked me–

Chuck: No, you don’t need a helmet.

Ed: That’s right, but it’s crazy. I don’t know what else– I’m sure he wanted me to be tried, wanted me to try out as a musician and X, Y, Z, all this. Nothing worked. I ended up doing what I’m doing by default. If you could–

Chuck: Something else worked out.

Ed: If you could find something that you’re passionate about, even if it’s in by way of a default, you know what you should do?

Chuck: That thing.

Ed: Do it.

Chuck: Right.

Ed:  It is the destination is the journey. It is not anything else. If you enjoy the stock market, if you enjoy the volatility, if you enjoy debt, if you enjoy the risk tolerance, then this is for you, and if you don’t, do something else.

Chuck: Exactly.

Ed: Chuck, we’ve been at this almost a half hour, and I don’t know that we’ve made any sense to anyone.

Chuck: Well, it made sense to me.

Ed: Well, so long as we understand it, but no one else probably understands it or cares. The last thing we want to do is talk to the registered investment advisors is when I discussed this with him. Oh, man, don’t you–

Chuck: We don’t like that debt. We got to get rid of the debt.

Ed: Are you nuts?

Chuck: Why aren’t you holding any cash? I know, we’ve had that conversation.

Ed: I’m sorry, cash is not king. Cash is a waste.

Chuck: Not in an investment account.

Ed: No, it isn’t.

Chuck: When you’re looking at a company, it is.

Ed: Oh, I want to see what–

Chuck: Cash flow.

Ed: Cash flow. Let’s be sure we’re talking about its earnings. EBITDA  earnings after interest, depreciation, and amortization. I want to see the cash that’s being produced and capitalize that 5%, 6%, 7%, 10%. That’s the value.

Chuck: That’s why the dividend yield.

Ed: Exactly.

Chuck: It proves to you that this company has cash to pay their investors. Everything else can look great, but if they’re not paying a dividend, you have to ask yourself, well, wait a minute, why not?

Ed: Let’s go through this capitalization before we sign off. Let’s assume you have an apartment building that yields cash, $100,000. What’s the value of that apartment building? Oh, you capitalize at 10%.

Chuck: Right.

Ed:   $1 million.

Chuck: $1 million.

Ed: At 5%, $2 million. Everything–

Chuck: Just so people understand, we’re taking the $100,000, we’re dividing it by the capitalization rate. $100,000 divided by 10%. That’s why we say it’s a $1 million. We’re basically saying we deserve a 10% return on our investment. If we’re getting $100,000 a year, that means it’s a $1 million investment.

Ed: Everything else throw away, as far as I’m concerned. Cash production is king. Not cash in your savings account or in your checking account. I am sorry. No, no. Why do you have cash?

Chuck: Right.

Ed:  The sophisticated investor will say, “No, we want to have cash take advantage of the investment opportunity.” My response is, “Well, what is an investment opportunity?”

Chuck: Right.

Ed:  That’s another series of investment decisions you’ve got to make.

Chuck: Right.

Ed:  If you’ve infinite this strategy, add to the positions, but again, I’m confident, I’m wrong.

On the other hand, the only time I thought I was wrong was when I was wrong. Okay, Chuck, I guess we’ll sign off for today. Nice visit.

Chuck: Same here.

Thank you for listening to Money Talk. Please join us again and do check out our previous Money Talk topics.


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