F Wall Street

1. Wall Street's interests often conflict with investors' goals

Your portfolio is at war with Wall Street. They want your account so they can sell you their investments . . . and generate more cash for themselves.

Wall Street's primary motivation is to generate profits for themselves, not necessarily to help investors achieve their financial goals. This conflict of interest often leads to the promotion of mediocre or even poor investments, excessive trading, and high fees that eat into investors' returns.

To protect yourself:

• Understand that Wall Street firms are businesses, not impartial advisors
• Be skeptical of "hot" investment tips and trends
• Focus on low-cost, long-term investing strategies
• Educate yourself about investing principles and company fundamentals
• Consider managing your own portfolio or working with a fee-only fiduciary advisor

2. Focus on cash flow and intrinsic value, not just earnings

Earnings are for the IRS and accountants; business owners and silent partners rely on cash.

Cash is king in business and investing. While earnings can be manipulated through accounting practices, cash flow provides a clearer picture of a company's financial health and ability to grow.

Key cash flow metrics to consider:

• Free cash flow: Operating cash flow minus capital expenditures
• Owner earnings: Net income + depreciation/amortization + non-cash charges - average capital expenditures
• Cash return on invested capital (CROIC): Owner earnings / (long-term debt + shareholder equity)

By focusing on cash flow, investors can better assess a company's ability to:

• Fund operations and growth without relying on external financing
• Pay dividends or buy back shares
• Weather economic downturns and unexpected challenges

3. Buy wonderful businesses at a discount to intrinsic value

The price you pay determines your return.

Intelligent investing involves identifying high-quality businesses and purchasing them at a significant discount to their intrinsic value. This approach provides a margin of safety and increases the potential for long-term returns.

Characteristics of wonderful businesses:

• Strong competitive advantages ("moats")
• Consistent cash flow generation
• High returns on invested capital
• Capable and honest management
• Predictable, sustainable growth

To determine intrinsic value:

1. Estimate future cash flows
2. Discount those cash flows to present value
3. Add a margin of safety (e.g., 25-50% below calculated value)

By adhering to this strategy, investors can minimize downside risk while maximizing potential upside, regardless of short-term market fluctuations.

4. Use owner earnings to evaluate a company's true profitability

Owner Earnings = Net Income + Depreciation and Amortization + Non-Cash Charges – Average Capital Expenditures

Owner earnings provide a more accurate picture of a company's profitability than traditional accounting metrics like net income. This measure, popularized by Warren Buffett, represents the cash that could be distributed to shareholders without impacting the business's competitive position or growth prospects.

Benefits of using owner earnings:

• Accounts for necessary capital expenditures
• Excludes non-cash accounting charges
• Provides a clearer view of sustainable cash generation

When analyzing a company:

1. Calculate owner earnings for the past 5-10 years
2. Look for consistent or growing owner earnings over time
3. Compare owner earnings to reported net income to identify potential accounting manipulations
4. Use owner earnings as a basis for valuation and investment decisions

5. Diversification should be based on your confidence level

Diversification = 1 / Confidence

Intelligent diversification is not about owning a large number of investments, but rather about allocating capital based on your understanding and confidence in each opportunity. This approach allows for concentration in your best ideas while still managing risk.

Guidelines for portfolio allocation:

• Industry leaders: 10-25% per position (max 40%)
• Middlers (mid-sized companies): Up to 10% per position
• Small fish (smaller companies): Up to 5% per position

Factors to consider when determining position sizes:

• Your understanding of the business and industry
• The company's competitive advantages and growth prospects
• The margin of safety in the current stock price
• The potential impact on your overall portfolio if the investment doesn't work out

Remember that diversification is a tool for managing risk, not maximizing returns. Concentrate your investments in your highest-conviction ideas while maintaining a prudent level of diversification.

6. Practice "assiduity" - patience in waiting for great opportunities

He who turns over the most rocks, wins.

Assiduity, or the ability to sit patiently and do nothing until great opportunities arise, is a crucial skill for successful investing. This approach allows you to avoid mediocre investments and focus only on the most attractive opportunities.

Keys to practicing assiduity:

• Develop a watchlist of high-quality companies
• Regularly research and value potential investments
• Set price targets based on intrinsic value calculations
• Be willing to hold cash when attractive opportunities are scarce

Remember that you don't have to swing at every pitch. By waiting for fat pitches – investments with a significant margin of safety – you can improve your long-term returns and reduce the risk of permanent capital loss.

7. Understand your investor psychology to determine strategy

The number one reason that people lose money or "just can't seem to make it" is because they are investing in a way that is inconsistent with their psychological comfort zone.

Self-awareness is crucial for successful investing. Understanding your psychological makeup and risk tolerance will help you choose an appropriate investment strategy that you can stick with through market ups and downs.

Four main investor types:

1. General Conventionalist: 100% bonds, CDs, and cash
2. Enterprising Conventionalist: 50% bonds, 50% blue-chip stocks
3. Safety Seeker: 50% blue-chip stocks, 50% value stocks
4. Non-Conventionalist: 100% stocks, focused on undervalued opportunities

Key factors to consider:

• Your comfort level with market volatility
• The amount of time you're willing to devote to research and analysis
• Your investment time horizon and financial goals
• Your ability to remain rational during market extremes

By aligning your investment strategy with your psychological profile, you'll be more likely to stick to your plan and achieve long-term success.

8. Bond laddering provides steady returns with minimal risk

Bond laddering is the best way to invest in bonds and other fixed income investments.

Bond laddering is a strategy that involves buying bonds with staggered maturity dates. This approach provides a balance between current income, interest rate risk management, and liquidity.

Benefits of bond laddering:

• Regular income from interest payments
• Opportunity to reinvest at potentially higher rates as bonds mature
• Reduced impact of interest rate fluctuations on overall portfolio

Steps to create a bond ladder:

1. Determine your investment amount and desired ladder length (e.g., 5-10 years)
2. Divide your investment equally among the chosen number of years
3. Purchase bonds maturing in each of those years
4. As bonds mature, reinvest in new bonds at the long end of the ladder

Focus on high-quality, investment-grade bonds (rated A or higher) to minimize default risk. Consider a mix of corporate, government, and agency bonds to further diversify your fixed-income portfolio.

9. Workouts can enhance returns in special situations

Investing in workouts is all about the annualized return.

Workouts are special situations, such as mergers, acquisitions, or bankruptcies, that offer opportunities for enhanced returns with relatively low risk. These investments typically have a defined timeframe and calculable return.

Types of workouts:

• Merger arbitrage
• Spinoffs
• Liquidations
• Tender offers
• Distressed securities

Key factors to consider in workout investments:

• The spread between current price and expected payout
• The estimated timeframe for completion
• The probability of the deal closing as expected
• Potential risks or obstacles to completion

Workouts can provide steady returns and portfolio diversification, especially during periods of market volatility. However, they require careful analysis and monitoring to ensure the potential reward justifies the risk.

Last updated: July 31, 2024