Gone Fishing ... Patiently

Cover Story, by Hugh McManus, Contributor

Posted on June 1st, 2013

This month Hugh takes a look at a discipline that has served him well, leading to the discovery of buying and accumulating opportunities among leadership companies over a few decades of long-term investing.

Not just fishing … bottom fishing. This month Hugh takes a look at a discipline that has served him well, leading to the discovery of buying (and accumulating) opportunities among leadership companies over a few decades of long-term investing. If the crowd is kicking one of your favorite companies when its stock price is down, chances are that it is in the crosshairs on Hugh’s radar. Seek the highest-quality companies and use your instincts to consider and treat them differently. Be choosy and patient, because “patience is genius in disguise.”

I was watching an old episode of Frasier last night and realized that I need to visit a psychiatrist. One that specializes in finance — an investing psychiatrist.

When I describe companies — the stock in companies — that I like, it’s kind of scary. I like companies that are recently scarred, bleeding is better; that aren’t popular with the in-crowd: shunned is best, the more socially awkward the better. I particularly love companies that don’t love me back. In a nutshell, I like self-loathing stocks.

Of course as is de rigueur when chatting with a psychiatrist, I can always blame my parents — I can even document their abuse. We’re not talking biology here. We’re talking intellectual parents such as Benjamin Graham or Phil Carret. They made me become antisocial. Their books teach that crowds are dangerous; be a loner. It’s easier said than done, it’s hard to go against the crowd; we’re social animals programed to believe that there’s safety in numbers.

When in a crowd, at work or at a party, I can’t really tell most people what I’m buying, because the company is almost always newsworthy, but seldom for a good reason. Think BP, a vacationing CEO and oil pouring into the Gulf. It’s hard to explain yourself without sounding defensive or, worse, carting out a soap box. Here’s a test: try being condescending when you’re in fervent agreement with someone — very hard to do. Now, try to avoid sounding condescending when the basic message is “I’m right, you’re wrong and here are multiple reasons why.” Outside of venues like Manifest Investing, I just don’t talk about what I’m buying. It really is hard to go against the crowd. When it comes to what I buy and who I tell, I’ve become a loner in many ways.

One of those news (or is it entertainment?) shows gave a great example recently. A person (the subject of a study) was secured in a room completing a test or some kind of form. Suddenly, smoke came billowing in under a door. The subject, who was alone in the room, reacted immediately, got up and tried to leave. The experiment was repeated, but this time a new subject was in a room with a dozen other people — people who knew what the experiment was all about. As the room filled with smoke, these new people didn’t react to the clear danger; the subject almost always followed their lead. It’s weird. It says a lot about us as a species. We take our cues from the behavior and reaction of other people even when there’s life-threatening danger: an example of safety in numbers.

When I first read The Intelligent Investor by Benjamin Graham, his basic approach seemed to be incredibly obvious. I was surprised that it worked as well as it did, because surely everyone would adopt his approach. I came to the happy realization that just because something is obvious doesn’t mean it’s self-evident. In fact, many of the factors that go in to buying a company are so obvious that you often have to say them out loud to realize the obvious truth.

Position Versus Selected Low Price

If a company is primed for long-term growth, buying it when the price is depressed is better than buying it when it’s at a 52-week high. If the stock price drops to a new low, there’s always bad news to explain the fall, which is one of those obvious truths. I had to learn whether I wanted to fixate on the bad news or focus on the low price of a good company. Most people seem to be transfixed by the news. I take it one step further and hope the bad news persists for a while — it’s where the psychiatrist would step in — as it allows me to buy more.

In 1997, or thereabouts, Ken “Mr. NAIC” Janke, commented that members of the organization were masterful at identifying quality companies, but not nearly as good at picking a low price. I had already adopted the practice of buying companies when they reached or were close to a 52-week low. It’s a rule not a law: for an idealized growth company, today’s close is the new 52-week low.

For such companies—and there are few of them—a nice dip works as well. I modified this rule in the late 1990s. Large companies tend to be more predictable than medium-sized or small firms: they’re often more diversified either geographically or in what they offer. I put more stringent requirements on mid-cap companies, demanding that the price be at or near a two to three year low; small companies (this I learned from biotechnology) should be four or five year lows. I miss many opportunities with this approach; it’s designed to preserve capital: protect downside. The company still has to be “good.” It still has to be an earnings machine that has hit a speed bump. I want good companies and bad news. I want short-term “investors” to leave, driving the price down.

Deciding on what constitutes a small, medium or large company isn’t always obvious. Sales is a classic way to do it, market capitalization is even more popular. MANIFEST uses sales growth which sheds even more light on the subject. I also divide companies, broadly, by technology versus traditional. I have learned that in the Internet age, there are many companies where the technology replacement cycle is much faster than the financial reporting cycle. Think of it this way. In 1992, Warner-Lambert (now Pfizer) was filing a patent for the active ingredient in Lipitor. Technology companies were filing patents on improvements to floppy drives or 56k phone modems. Lipitor is still a viable drug. Tech companies have undergone a dozen or more product cycles over the same time. If a company lies outside the traditional core of retail or manufacturing, I look for multi-year lows. For Apple, a big company in many respects, I want a three year low.

A Version of Hugh’s Low Price Position Screen. Using the Value Line Investment Analyzer, we built this screen that incorporates many of the attributes of the method. Eligible companies were limited to a Financial Strength rating equal to B++ or better. The selected Low Price is based on the EPS Predictability. For companies with an EPS Pred of 80-100, the 52-week low price was retained and used. For EPS Pred of 60-80, we used the 2-year low price. For EPS Pred of 40-60, the 3-year low was used, etc. consistent with the approach.

A number of companies close to the top of the results using 52-week lows were disqualified or jettisoned when ‘switching’ to the multi-year lows as directed by the historical earnings predictability… or unpredictability. In other words, the greater the volatility, the more likely the Position calculation (Current Price/Selected Low Price – 1) would increase and be removed from consideration. Hugh remarked that his interest is sparked by a Position of 25% or less. [Value Line, 5/31/2013]

Kissing & Making Up Is Fun To Do

Walgreen (WAG) is a nice recent example. Last year the price dropped under $30 per share for a few weeks: it was a happy time. I started buying it once the price hit $32. Aside from the skirmish with Express Scripts, nothing fundamental had changed. It was in the best interests of both companies to kiss and make up, which they soon did (just in time for a Walgreen annual meeting.) Within a year, the stock price not only recovered, but approached the all-time high reached in 2006.

This first rule, “buy low,” has a corollary: buy lower. I am a regular investor. If I think that the price is good, the company is primed for long-term growth, and the price drops some more, I buy more. If I haven’t changed my mind about the company, I keep buying; you’ll eventually hit the 52-week low. I’ve done it once! As long as the price is depressed and close to its 52-week or multiyear low, I keep buying, week after week, until something better comes along. I have found that eventually, diversification takes care of itself.

Buying at a multi-year low is one thing, but there are lots of companies with depressed prices. Which brings me to a second television adventure: a story about lions on the Serengeti. I love those documentaries. The two consistent traits possessed by lions are that they’re lazy (applies mostly to the males) and they pursue the weakest or injured prey. I have followed their lead, stalking companies undergoing a moment of weakness or suffering from what I hope is a temporary setback. It’s a great way to find a low price; it also brings out a chorus of naysayers.

Bank of America (BAC) is a good example of a wounded beast. In fact any major bank was prey. The argument for avoiding banks could get quite complex; however, the argument in favor of buying them was really quite simple. For hundreds of years a growing economy needs a firm to facilitate financial transactions and to be a source of credit; banks provide those services. Without banks, there’s no modern economy. If the economy recovers, so too will banks. If banks don’t recover, the economy will stall. We saw a fine example of this second proposition back in September of 2008. Major banks are today like the financial equivalent of Noah’s Ark as Bernanke and Paulsen crammed weaker companies onto them, but they are slowly correcting themselves. Bank of America, a different animal than in 2008, will ultimately resume a reasonable 20 to 30 cent dividend; interest rates rise and profits will return.

Staples (SPLS) is a current example of a wounded animal. The economic environment is tough for Staples and its competitors; the price, until recently, was depressed, so I bought frequently. If you look at this retail space, Staples is the best of the bunch. It can coupon away in a knife-fight with Office Depot and Office Max: Staples has its on-line business pumping out cash. In fact, after Amazon, Staples is the second biggest e-tailer in the country. The office supply ecosystem will change—Amazon has entered—but, in my opinion, Staples is the best legacy company in this space. It will win the marathon back to sustained growth and profitability. I will buy more shares if the stock price dips again.

There’s another thing I like about wounded companies: when the earnings engine has problems, you find out how that earnings engine really works. That’s where the “lazy” party of the lion analogy comes in. These aren’t turnaround stories, where the basic business model is being changed; these are companies that have stalled, but will ultimately resume doing what they did before. When it comes to learning about these companies, other people will do the work if they see blood in the water. Multiple articles appear with early drafts of an obituary for the company. Such articles give a nice fresh perspective on the business model and finances, multiple, opinionated primers on how the company works. It’s a good time to learn and develop an opinion about the future. For a long-term investor, if the earnings engine is intact, the company will recover. Bad news is transient. For those with a time horizon of ten or twenty years, such news is a blip.

In summary, I have learned over the years that it’s really hard to beat market averages by focusing exclusively on the upside: I watch my back. I protect my downside to the extent that I can and add a 1 to 5 year low price into the mix of other factors. I also have learned that most people think short-term. We’re primed to act that way. I look for good companies suffering hard times; such companies will take time to recover. I try to get beyond the news: there’s always bad news when a company hits a multi-year low. It’s worth repeating that it can take time to recover. They’re examples of the adage I love: patience is genius in disguise.

Expected Returns, Jun 2013

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