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Dear Tom and Lindsay
A letter to my friends about my investing philosophy
Tom and I have been best friends since we first shared a dorm room during our sophomore year. He has thus been a fly on the wall for most of my investing career. One day he asked me to help him set up his own brokerage account and I was honored. We have been buying stocks together ever since. I come up with the ideas and then we discuss their validity.
Fast forward, Tom is with Lindsay and she too has a brokerage account for investments where I am a sounding board with ideas. They both have fruitful careers with retirement plans from their jobs but want to hold some individual names in their Roths. Overall, these accounts are not a large portion of their net worth so they are comfortable with the risks that come along with individual stock investing.
They asked me, for the first time, to put on paper a list of my ideas and why I like them, and although I am going to keep those names private until I can put together a more formal post, here is the cover letter I sent to them to set the scene. I hope it helps frame my investing philosophy for you.
Let me be clear, I am not compensated whatsoever by them. I am not their financial adviser and I am not their investment advisor. They make the final decisions.
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Dear Tom and Lindsay,
A few weeks ago, you both came to me with a similar question, “Could you do me a favor and write down what ideas you like and why?”
I’ll be honest, I have been looking forward to this day but before we get into the nitty-gritty, you should understand how I look for ideas and my general expectations around them.
At the heart of it all, my strategy for selecting investments revolves around the notion of trying to identify situations where there is a severe dislocation between the value of the business and the current stock price shown in the market.
In my eyes, ownership of stocks is the same as ownership of any other type of asset. An apartment house or a local restaurant for example. And the way I go about trying to estimate the value is the same for each. It all comes down to the amount of cash an owner could take out of the asset throughout its lifetime.
The old saying goes, “A bird in the hand is worth two in the bush” Well investing is about giving up the bird in the hand for the two in the bush and the important questions are, how many are in the bush and when are they going to come out?
I like to find situations where we are giving up one today because I think there are two or more in the bush that I think will come out within 5 years. (This implies a rate of return of ~15%)
The opportunity to turn $1 into $2 in five years can come in all shapes and sizes but it all goes back to the point above of the difference between price and value.
There are some names that I think are $1 bills (value) selling for $.50 (price) and we are simply waiting for a price correction. The correction will likely happen due to an internal event causing a reevaluation of the name.
What this means is the company is going to do something to close the price-value gap whether it's paying a dividend, selling off part of a segment to show its true value, or buying back 25% of the company over the last 3 years.
These actions are what we call catalysts and although we are buying at a discount to the true worth of the business, we look for an event casuing the value to unlock in a reasonable time frame. The opportunity cost of a name sitting still for years is too much.
The other names are companies that have bright futures ahead and show no signs of slowing down. I believe these to be wonderful companies and the only real decision one needs to make is to buy when they are out of favor and hold on for dear life.
In these situations, I try to estimate the forward returns of the company by using a simple formula. Your rate of return is equal to your cash flow yield on day 1 plus any growth in your share of cash flow over the holding period of an investment.
For example, if we buy a company that is currently trading for 10x cash flow, our day 1 yield is 10% and if we expect our share of cash flow to grow at 5% a year for the next 10 years then I would estimate our total return to be roughly ~15% a year for the 10 years. This is very basic math and isn’t perfect but can be helpful as a rough gauge. It shows you that the returns we achieve as owners are based on the performance of the operations of the business.
For me a perfect investment situation can be summed up by an excerpt from Carol Loomis’s book, Tap Dancing To Work. Here she is describing what Warren Buffett looks for:
“These days, his notion of an ideal opportunity is to buy into a business for $1 million when it is really worth $2 million and will be worth $4 million in five years. Such situations, he acknowledges, are not easy to find. “We don’t have a lot of good ideas,” he says, “and therefore we don’t do a lot of things.”
At the end of the day, if I work relentlessly to focus on identifying situations like the one described above, I believe we have a good shot at compounding our capital at rates above those one could obtain by simply owning the S&P 500.
For some, the passive approach is reasonable and rational, but I think the effort of seeking out investment opportunities that have the potential to outperform the benchmark is well spent even if it only adds up to a few percentage points of outperformance over a lifetime.
Below is a chart of what those small points add up to over 40 years.
Here is what 1,000 dollars turns into when compounded at the following rates for 40 years.
10% (the average): $45,259
As you can see, the efforts are worth it.
I will leave you with this, what we are doing when buying stocks is buying portions of businesses that are currently selling for less than they are worth and waiting for the market to recognize the true value. How long that takes can be gauged in terms of years, many investors have guided to 3 years being the mark of when to “result” an investment decision. I agree.
It will require extreme patience to see these ideas come full circle. So, disregard all market forecasts, noise, and short-term price swings. I think like an owner and I am in it for the long haul.
Please be advised, Wall St Gunslinger is not an investment advisor and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investment decisions. Thank you.