Feynman Investment Research LLC philosophy/strategy
I believe it is crucial to have a written, flexible investment philosophy in place before even considering making an investment in securities of public companies. Having a plan increases your chances of succeeding in a field such as investing, which is partially prone to bursts of bad or good luck, especially on the short-term. Moreover, a plan is similar to a lifeboat in times of distress or personal doubt- it provides much needed guidance when you need it the most.
When I first started investing, I did not have a solid investment strategy, and as a result, I made a few unsound investments and suffered avoidable loses. Going through difficult times and having a loss at some time is unavoidable, even for investors such as Buffett and Munger- what is not acceptable is the inability to prepare for prevention of those loses. Being prepared by having a sound philosophy and sticking with it, through easy and tough times, is the hallmark of a great investor/ businessman.
Although an investment philosophy can serve as a protective shield to an investor, it is effective to the extent that it is grounded on sound, reliable and persistent principles. It is wise not to delude oneself by having an investment philosophy that looks good on paper, but is predicated upon shaky grounds. In the following section, I will describe what constitutes a sound and coherent investment plan.
If you were to ask a typical value investor regarding the definition of value investing, you would receive answers such as:
– Purchasing a security at discount to intrinsic value and applying margin of safety.
– Buying a dollar for 50 cents.
– Being greedy when others are fearful, and being fearful when others are greedy.
Value investing is indeed all those things, but at the same time I believe, if we were to describe value investing by just what is listed above, we would get a provisional, incomplete understanding of it. Let’s analyze step by step the three statements above:
– Purchasing a security at discount to intrinsic value and applying margin of safety
It is not enough to purchase a company that’s undervalued and applying margin of safety. You need to investigate the quality of the company and management before making such a purchase. A company might be theoretically undervalued, but if it not at least of average quality, the catalysts that are needed to unlock the gap between price and intrinsic value might not be actualized. It is tempting, especially for beginning investors, to buy a company that is trading at a discount and hope that intrinsic value will be materialized- however, that day might never come, if you do not perform a thorough analysis of the company and reasonably assure yourself to the high quality of the company.
– Being greedy when others are fearful, and being fearful when others are greedy
A contrarian mindset, although a necessary component of being a successful investor, is not enough. You need to be right when others are wrong, and even then, you need to assess the probability that your correctness will eventually materialize and not be overruled by the wrongness of the others. For example, there are successful short- sellers, who I believe were correct in their assessments of their investments, but they never realized a gain, because of the overwhelming power of the others to remain steadfast in their conviction, despite the facts proving them wrong. This phenomenon is not as strong in long only investments; however, you need to be careful to not engage in investments that are overpowered by the wrong, steadfast conviction of others.
Type of company: I believe in investing mostly in high quality companies that are currently undervalued, and have strong prospects of unlocking their intrinsic value in the next 2-3 years. I might hold the company for a longer time, if the facts warrant it, but 2-3 years is often times necessary to unlock intrinsic value.
Size: I focus on micro&small cap companies, as I believe there is a high potential for generating alpha by carefully selecting under-valued, under-followed, high quality small cap companies.
Industry: I am not industry specific- I go where the value is. However, I am not comfortable with banking companies and technology companies- banks often times contain hidden mines, and technology companies like Facebook enjoy only temporary competitive advantages. However, that is not to say, that banks cannot make attractive investments in times of economic distress- good banks such as Wells Fargo, can suffer temporarily declines, like the rest of their peers who are not as fundamentally sound( that is a good time to consider making an investment)
How to find value
Stock screeners: Stock screeners are an indispensable tool in the search for value. I prefer stock screeners from www.finviz.com, www.gurufocus.com, www.valuewalk.com and www.oldschoolvalue.com . It is important to be flexible through screening companies, and to switch the parameters of your search now and then. The 52- week list is a fantastic place to find some bargains.
Value investing websites: Investing websites are a good hunting ground for value investing ideas. It is important not to be swayed by arguments that sound good, but do not have much meat behind them. For this reason, when I look at the profile of someone who provides an idea that sounds good, I always do my due diligence and look at their previous ideas and rate of success. Some good investing websites are: www.cornerofberskhireandfairfax.ca, www.valueinvestorsclub.com ( probably the highest quality one), www.seekingalpha.com( you need to be careful with some authors on this one, as this website contains high quality, medium quality and low quality ideas, unlike Corner of Berkshire and Value Investors Club, that contain mostly high quality ideas), www.theinvestorspodcast( some really good ideas and discussion on this one, and it is a really small community at the moment)
Books: The more books you read, the sharper you thinking gets and you find more investment ideas- it is as simple as that.
Friends/ associates: When someone I trust, presents an investment idea to me, I listen. It is important to not be swayed by your friend’s argument and treat their ideas the same way you would treat them if you got them from some other source. I only listen to ideas from high quality thinkers/ investors. Life is too short to search for ordinary ideas.
Successful hedge fund managers/ investors: From time to time, I look at ideas and holdings from top value investors, and attempt to find and shamelessly clone high quality ideas from them. Don’t mindlessly copy ideas from top investors though, always perform in-depth, due diligence. Remember: they can afford to lose money, you cannot and should not. Some of my favorite investors are: Warren Buffett, Charlie Munger, Carl Icahn, Seth Klarman, Joel Greenblatt, Mohnish Pabrai, Jeff Ubben, Bill Ackman, David Einhorn, David Tepper etc.
Once I find a company from the ways listed above, my first step is looking at the financials of the company. If the company does not satisfy my financials checklist, it rarely, if ever, makes it through my first step.
In the first step, I take the company through the grinder, i.e see if it satisfies several hurdles. Most of the hurdles in the first step, are financial.
ROIC: I look for consistent, predictable and reliable ROIC for the past ten years of around 12-15%. Closer to 15% is very satisfactory. Much higher than that is better sometimes, but it is not sustainable and attract competition very quickly.
ROE: Again, consistency, predictability and reliability of this metric over past ten years is crucial. For this one, I look for 10-12%.
ROA: Same as ROIC and ROE. For ROA, I like at least 7-8%.
Gross Margins: Not to beat a dead horse, but consistency, reliability and predictability of gross margins is vital. For gross margins, I have a much higher hurdle: I look for at least 25%.
Net Margins: This metric is somewhat prone to potential manipulation by management, but the higher the better. History of net margins is very important.
Operating margins: Very similar to net margins.
Free cash flow: Free cash flow yield is very important. I look for around 8-10% as a rule of thumb.
Gross profits: I prefer them steadily rising over the years.
EPS( Diluted): I look for diluted EPS growth over the years.
Those nine metrics: ROIC, ROE, ROA, Gross Margins, Net Margins, Operating margin, Free cash flow yield, Gross Profit and EPS(diluted) are what I call level 1 metrics( level 1, means of highest importance).
Now, moving on to level 2 metrics ( level 2, meaning of high importance)
Debt to equity: The lower, the better. Less than, or around 0.5 is solid.
LT Debt to Total Assets: Same as above. Less than, or around 0.3, is solid.
Interest coverage: The higher, the better.
Quick ratio: Better than 1 is preferable.
Current ratio: Better than 1.5 is preferable.
Next, I look at various metrics such at what P/E, P/B, P/S,P/FCF and EV/EBIT.
I do not have specific hurdles set in stones for these ratios, but is very important to see how they relate to historical numbers, the industry the company is operating in and the overall market level. When I first started investing, I was a big fan of P/E and P/B, but with time and evolving, I have grown to like P/S, P/FCF and EV/EBIT more. That’s not to say that P/E and P/B are not important.
If I am satisfied with the financials of the company, I usually perform a DCF calculation to arrive at an estimated intrinsic value range for the company. I perform bear, base and best case scenarios. I try to be realistic and not overzealous with my estimates. I use conservative discount, terminal value and free cash flow growth numbers. Depending on the company, I might use single stage, or multiple stage scenarios. Sometimes, however, the discount to intrinsic value is so obvious that you do not need to be over-concerned with doing an exact DCF calculation. I look for at least 25% discount to intrinsic value, and add 5% margin of safety, for a total purchase discount of at least 30% from current company price.
After I am satisfied with the financials of the company, and it is undervalued, I look at the 10-Ks for the past three- five years, in order to get a deeper understanding of the company. Some of my favorite sections of 10-Ks are: Management Discussion and Analysis ( MD&A), footnotes, proxy statement, risk factors section.
When I believe, I have a more detailed understanding of the company, I start listening to quarterly conference calls for the past 2-3 years. I look for deviation from what management said in 10K report to what actually happened. I am also interested in management that takes responsibility for mistakes and starts correcting them. Once you listen to enough conference calls, you can notice what management team is honest and on point, and what management team seems evasive and dances around the question.
I start looking at the general dynamics of the industry and its strongest players. I prefer industries that are oligopolies or near-monopolies, versus industries with intense competition. I also like the companies that I invest in, to have large shares of the market, and other competitors to have small, fragmented rest of the market share divided between them. Generally, a company that has been a market leader, can be expected to remain a strong competitive player, but you need to look at current conditions and try to realistically predict how strong can the company be over the next couple of years.
I try to gain a general understanding of the current state of the economy and how it might unfold in the short-term; however, it is very difficult to predict bullish or bearish conditions with accurate timing, so I continue to invest in whatever company I have chosen as a suitable investment candidate, despite what might look like unfavorable economic conditions. Unless economic conditions are dire, or near dire levels, I am not persuaded enough not to make an investment.
Step 6 basically concludes the buying process. I buy gradually into my investments, and add to the positions if they deteriorate for non-fundamental reasons, or if they show improvement in their intrinsic value.
Monitoring of investment
Once I make an investment, I monitor it once a month or so. I have high conviction in my ideas, so it is not really necessary for me to monitor it more frequently. When a company that I have invested in, decreases in price temporary for reasons that are not fundamental, such as market pullback or sector pullback, I add a bit more to my position.
Most of the time, I just wait for the stock market to pitch me more attractive ideas. In the meantime, I read all kinds of books to distract myself from the itch of wanting to be invested continually in the market and making new investments. In addition to reading books, I try to follow “stoic” philosophy and not be disturbed by temporary market volatility. I have gotten really good at not caring about market prices, although initially, I was concerned about them. I believe, putting my own capital at stake has proved to be a helpful experience in growing as an investor and having internal strength.
I sell when the company reaches 85-90% of intrinsic value, or thereabout. Other conditions that I consider when selling an investment are:
– Finding a much better investment
– Fundamentals of the company have deteriorated or were not as strong as I thought( has happened only twice at the beginning of my investment journey)
– Around 10% for high conviction ideas. On special occasions, 12-15% for extremely high conviction ideas.
– Concentrated portfolio with around 15-20 companies.
– Overwhelmingly common stock.Occasionally, preferred stocks or bonds depending on the company/situation
– No leverage, no margin