Snap Inc., Not an Investment.

Snap Inc, “the camera company” IPO’d on March 2, 2017. Snapchat is popular and useful to those who use it.  It is a prominent player in the currently expanding market in visual media on social media. Therefore, admirers of Snap products might be attracted to the Snap Inc IPO as an investment.

Does Snap meet criteria of an Amateur Investor investment?  Let’s go through them.  The first criterion of an Amateur Investor investment is the presence of a sustainable competitive advantage, such that the company sells a product that is indispensable to its users.  It is virtually certain that in 10 years the company will still be dominant in the market for its product.

Will Snap be dominant in its market in 10 years?  Let’s back up and ask a simpler question.  Will Snap exist in 10 years?  Hmm… Why not back up again and ask a different question.  Did Snap exist 10 years ago?  Of course, the answer is no.  How could we get an idea as to whether similar companies had sustainable competitive advantages?  Oops, I guess the word “had” kind of gives it away.  As chronicled in this lovely Wall Street Journal article (I recommend subscribing to and reading the Wall Street Journal, especially Business section, because its articles are simply narratives based on facts, unlike articles in some other high profile newspapers (I won’t mention the New York Times)), a number of social media wonder stocks have climbed to the height of stardom and then fizzled when least expected, not necessarily even going out with a bang.  For example, Twitter has over 319 million users, but its market value has fallen by more than half since its 2013 IPO.  Friendster back in the first decade of the 2000s had 75 million users before fading. Other somewhat less successful social networks are mentioned in the article. There is evidence that Snap does not dominate its market and is not indispensable, in that Instagram’s launch of Stories, a feature similar to snapchat, resulted in a significant slowing of Snapchat’s growth.

The second criterion for an Amateur Investor investment is that the company adapts by evolving its competitive advantage into evolving new markets.  Since Snap does not have a competitive advantage, it does not meet this criterion.

The third criterion addresses devotion to shareholders, for instance by making sure shareholders have voting power commensurate with their stock ownership, obtaining a good return on investment in acquisitions, avoiding stock dilution and so on.  In fact, the shares floated in the IPO on March 2nd do not have any voting power at all.  They are Class A shares, with no voting power.  After the IPO, close to 90% of the shareholder voting power is held by the two cofounders, Evan Spiegel and Robert Murphy. They hold all the Class C shares, which have 10 votes per share.  I didn’t even bother to look up who owns the Class B shares, which have 1 vote per share. Because Amateur investors would not be able to get ahold of those anyway.  Why does this matter?  Say in a few years (or months?) Snap decides to acquire another asset, say another company. In order to raise the necessary cash, it floats a large amount of Class A shares (only about 25% of these were sold in the IPO), thereby diluting the shares in the market and causing the price to fall.  Suppose many stock holders disagree with the wisdom of this acquisition.  What can they do? Can they vote against it as in a normal company? No, there is nothing they can do.  The founding company owners are already wealthy, they are not affected.

The fourth criterion for one of my investments is that the company must be at least 10 years old.  The fifth, that the investment is worthwhile based on the company’s past achievements, not just its hoped for future attainments.  The Sixth criterion addressed good return on investment, including low debt level, growing free cash flow, high gross margin, high ROI.  Snap has no earnings, in fact its losses of over half a $ billion exceeded its revenue of about $400 million.

In a nutshell, it is not possible to be sure whether Snap will still be going strong in 10 years.  It might, but then again, it might not.  It has no earnings.  Why take a chance speculating with your hard-earned money by buying this new company, when instead you could buy a company which you could be sure would grow and continue to be extremely strong and successful for the foreseeable future?

For inexperienced investors that feel they want to try buying something they like, I must agree that gaining some experience in the stock market, if it is with a very small amount of money that you can afford to lose, might be a way of stimulating and motivating the emotional learning process needed to learn about proper investing.  There are people who say you should not invest at all except with money that you can afford to lose.  But we Amateurs know that is nonsense.   Investment, as Benjamin Graham stated, is a purchase that upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative. There are various approaches to investing that could satisfy this definition, depending chiefly on what you, the individual investor, judge to be an “adequate”, satisfactory return.

In the Amateur Investor approach to investing, you must simply learn several important realities about businesses, the most important having to do with competitive advantage, of a durable nature.  You are looking for the company of which in 10 years it will be said “in 10 years this company will still be growing and dominating its market, and evolving and adapting to continue extending this dominance into the changing market.”

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Portfolio Performance for 2016: underperformed, but businesses doing well

Performance of my portfolio for 2016 was only 7.4%, underperforming S&P which made 9.54%. 

On 12-31-16 the relative proportions of holdings were

 

MSFT 49.9%

V 22.7%

SBUX 15.2%

CNI 5.59%

ADBE 4.98%

Cash 1.43%

 

No stock trades were made this year.

Beginning with Q2 2016 dividends were credited to cash instead of reinvested, to build a reserve for future purchase of stocks when they should reach an attractive low price. 

The performance of my stocks in the market was as follows:

 

MSFT    +14.65%

V           +1.36%

SBUX     -6.1%

CNI        +22.67%

ADBE    +9.59%

 

Possible causes of the relatively low performance are as follows. 

In the market volatility in September 2015 and January 2016, the S&P fell 10% from its peak of 2126 on July 17 2015 to 1921 on September 4, 2015, before climbing again to a peak of 2099 in November 6, then falling 12% to 1864 on February 12, 2016.  Unfortunately, I had no cash ready to invest in order to take advantage of the attractive low prices which appeared during the dip.  That is one reason that my performance was lower than it should be.  To address this, as mentioned above I began setting aside dividends to build a cash balance to fund acquisitions at attractive prices, whenever these should appear.

Another reason was that SBUX and VISA had suboptimal years in performance, although not as businesses.  SBUX missed revenue expectations for the first threequarters of 2016, then beat in Q4.  It beat earnings in Q1, met in-line in Q2 and 3, and barely beat in Q4.  The stock price more of less followed these results.

During 2016 Starbucks began developing its strategy of “premiumization” of the Starbucks experience, with the Roastery flagships stores and the Reserve category of Starbucks stores.  The various initiatives to expand the Channel Development segment continued.  The Full year 2016 revenue rose 11% and non-GAAP EPS 17% yoy, so hardly a poor showing.  The trailing PE is currently about 30, which is approximately average for recent 10 years. The continued evolution of SBUX to strengthen its competitive advantage and adapt to new markets is intact.

VISA acquired VISA Europe on June 21, 2016, for €12.2 billion ($13.9 billion) and €5.3 billion ($6.1 billion) in preferred stock, convertible to VISA Class A stock, with an additional €1.0 billion, plus 4% compound annual interest, to be paid on June 21, 2019.  To pay for this, VISA in December 2015 issued $16 billion of senior notes with maturities ranging between two and 30 years. The acquisition was expected to be dilutive to earnings in 2016 in the low single digit range. 

Stock dilution is being offset as the $16B debt issuance is being used partly to increase stock buy backs.  The acquisition should be accretive in low single digits in 2017 excluding integration costs, and accretive in high single digit range by 2020.  The increased earnings are partly from increased efficiency:  increased scale, cost cutting efficiencies realized by integration of the businesses, and benefits related to Visa Europe’s transition from a member-owned association to a for-profit enterprise. VISA Inc. will be positioned to take on the estimated 37%, or USD $3.3 trillion, of personal cash and check spending in Europe. Europe has been an early adopter of mobile payments using NFC, expected to grow.  Visa Inc. has aggressively launched new mobile payment partnerships, platforms and products that will enable faster growth and adoption of mobile payments in Europe. This includes new tokenization services, support for digital wallets and wearables, strategic investments in other enabling technologies, ecommerce (such as VISA Checkout) and P2P payment capabilities, as well as the opening of several global innovation centers. 

VISA will be able to present a seamless experience and global capabilities to its European and international clients.  Hence the evolution of VISA Inc. to strengthen its competitive advantage as digital payments global market leader, and adapt to serve evolving markets, is intact.

 

VISA Q1 2017 Earnings, harvesting market growth, ploughing and sowing for the future

2-4-2017.  VISA Q1 2017 (2-2-2017) earnings call was led by Alfred Kelly Jr., who became CEO, replacing Charlie Scharf on 12-1-2016.  Al Kelly graduated from Catholic, Christian Brothers affiliated Iona College, in Westchester, NY, with undergraduate and MBA degrees. He worked in the Reagan White House as manager of information systems (using DOS, or Windows 2.0?) from 1985 to 1987, then held a range of important roles at American Express for the next 23 years.  He has been on the VISA Board of Directors since 2014 and therefore played a role in approving the current strategy. 

In the earnings call, Kelly noted that VISA strategy will remain as is, in a seamless transition with the previous CEO. He noted VISA has a talented leadership team; strong relationships with issuers clients, acquirer clients and merchant clients. It is important to learn about and address their business needs while reducing friction in and enabling digital payments. VISA is in an industry with strong growth. In developing markets, middle classes and governments are demanding payment digitization. In developed markets, ecommerce and mobile payments are displacing checks and cash. VISA is a leader in payments technology and constantly supports innovation in ecommerce and novel forms of payment digitization.

I will address the overall strategy of VISA, which describes how VISA fills a key criterion of an Eternal Company investment: the ability to extend its competitive advance into evolving new markets, in a separate post.

Following is a summary of Q1 2017 financial results.  Rev and EPS exceeded expectations as accelerating business more than offset exchange rate shifts.  GAAP Q1 rev up 25%, EPS 7%. Adjusting for the non cash gain in Q1 2016 from writing off the VISA Europe put, adjusted EPS up 23%.  Payment volume growth increased 1-2 % in most geo regions. Cross border payment growth accelerated 2% from 10-12% globally excluding VISA Europe. Including VISA Europe impact, they accelerated 10%.  Process transaction growth accelerated 15 from 12-13% driven by India and US.

Did not issue 2$ Billion in debt as panned to finance VISA Europe acquisition as well as other costs. VISA has 8$ Billion offshore, will await Trump plan for corporate tax reform which may well allow cash efficient cash repatriation. Until then, used commercial paper issuance to fund stock buyback and operating cash needs.

The only region with reduction in growth was Latin America, due to Brazil. 

The integration of VISA Europe is proceeding and will continue throughout 2017. Europe represents meaningful growth opportunities, with large opportunities to displace cash.  Plan to advance digital payments by rolling out tokenization, VISA Checkout, and supporting digital wallets.   VISA continued to focus on local market priorities alongside client engagement. The vast majority of VISA payments volume in Europe remain under contract and is therefore protected in the short term.

The deliberate process of consultation of VISA Europe staff was completed later than expected. New hiring, investment to integrate technology with that of the international VISA system are adding expenses as planned.   As cost reductions are realized and Europe clients access global VISA capabilities,  earnings will accrete and value will be realized for shareholders, as planned since the takeover was announced.  Equity dilution related to the purchase is being offset by accelerated share buybacks. 

In India, Aggressive demonetization measures pushed by the government resulted in doubled transaction volumes but little revenue growth. Responsive to request by the Indian Government, VISA charged no fees for processing through 12-31-2016.  VISA regards this as an opportunity to expand the network and acceptance internationally, focusing on building customer awareness and merchant acceptance 

Kelly articulated “So.. when you consider the economics of the investment we will make in India, plus conservative pricing, it will not drive much profit this year. But this is a great year to make sure we do everything we can in one of the two largest population countries in the world to get as good a position as we can to help us over the next decade. “

I would like to make two observations on this lovely sentence.

1. It prioritizes strengthening the company competitive advance for the long term over short  term profits

2. the nature of the VISA business supports long term investments such as the one mentioned because of its competitive advantage.  The VISA services introduced into the developing India market will still be indispensable in 10 y.  As long as VISA continues to support successful innovations in payments, while nurturing and strengthening its network security and reach, it will undoubtedly maintain its relevance and dominance in the market. 

 

 

 

A sensible policy for cashing and saving dividends to invest in volatile high growth stocks at infrequently occurring low prices

1/18/2017 16:56

In the market volatility in September 2015 and January 2016, the S&P fell 10% from its peak of 2126 on July 17 2015 to 1921 on September 4, 2015, before climbing again to a peak of 2099 in November 6, then falling 12%  to 1864 on February 12, 2016.  I did not have a source of cash with which to take advantage of some really attractive bottom prices in stocks, specifically ADBE.  I resolved to find a way to take advantage of the low prices which appear in market dips, as purchases made in teeth of market terror are key to producing the most outstanding returns.

The purchase additional stocks for the portfolio must be funded either from the sale of current holdings or from cash kept for the purpose (I do not consider the use of debt to be a sound option).

There are various arguments against the sale of current holdings to simultaneously fund new purchases.  The decision to buy is driven by the identification of a prospective purchase that is currently found at an attractive, low price, or where business prospects for the company appear to be more promising in the immediate future.  Meanwhile, to optimize return, the company that is sold to fund the purchase would be judged to have less promising prospects and hence likely to fall in price, either because it is currently judged to be overvalued,  or because business prospects appear uncertain in the near future.  But there is no particular reason that the advent of an attractively low price in the target purchase would coincide in time with an attractively high selling price in another holding.  Rather, one may be faced with the prospect of selling a stock at a merely reasonable price to enable the purchase of a stock which is found to be hopefully at a nadir.  Unfortunately, the decision can potentially be wrong on both sides, that is, the price of the target purchase may subsequently fall even more, while the sold stock may subsequently continue to rise.

A variation of this strategy is to sell a stock that seems overvalued, or is expected to fall in stock price, in order to build up a cash reserve to fund purchases of a stock in the future, rather than simultaneously.  The problem with this strategy is that it  based as it is on prediction of the future, a sketchy enterprise at best. 

Indeed, the problem with any approach based on predicting the future of stock prices is that stock prices do not necessarily reflect current business events in the company in question at all.  They may rather reflect the market’s shifting reaction to those events, in turn driven by entirely distinct and distantly related social or economic forces.  Because of this, a stock that seems overvalued, and thus a likely candidate for harvest, may continue to rise into regions of continued overvaluation if social or economic sentiment looks favorably upon it, against conventional rational business expectations.  In this case, the sale price would be regretfully too low, too soon. Or in fact one may decide the stock should after all have been held for the long term.  Conversely, the tide of market sentiment may tumble a stock even though the company is prosperous, producing regret that one did not harvest at the previous peak.

One characteristic of my investing approach is the attempt to recognize and understand the emotional currents underlying  investing decisions.  By doing so, one can steer a course that is free of emotional hazards to sound investing decisions.  In the present case, awareness (perhaps not fully conscious) of the shakiness of one’s predictions about future prices is likely to cause anxiety which interferes with rational trading decisions.

One cannot change a future outcome that one does not control, either before it happens, or after it has happened.  But since no one else can either, failure to do so does not impair one’s performance relative to other investors, that is, relative to the market.  What one can do is first, avoid the chances of making an error, while maximizing the chances of better results, and second, minimize the emotional influences which interfere with sound investing decisions. 

A different strategy is to build up cash reserves to fund stock purchase.  In the absence of new cash, the only possible source of these is stock dividends credited to cash instead of reinvested.   These have a few advantages as a source of cash.  First, the cash is contributed regularly, at a range of different stock prices, so that no bet is made that a particular price would have been the optimal selling price.   Thus, one avoids the chance of making a large error in choosing a sale price which may turn out later to have been the wrong one.  no specific decision must be made to sell a treasured holding, with the accompanying distress.  This will minimize the emotional turmoil which leads to hasty, ill thought out decisions.

There are thoughts pro and con this strategy.  Crediting dividends to cash means they will not participate in the hopefully continued rise in the stocks they were contributed from.  In order to make this strategy worthwhile, one needs to buy new investments at a low enough price, or to achieve a high enough return on investment, so that this will compensate for the time of missed returns before the cash was invested.

Purchasing at a discount from the long term stock growth rate is crucial to maximize the chance of a good outcome.  If the stock fits criteria for the portfolio, none of which depend on short term market action, then its long term growth rate should approximate that of the portfolio.  The cash that is held pending the new stock purchase has a return of 0%.  Let us assume that the stock to be purchased would have a certain price at the time of purchase, if the stock was adhering continually to the long term portfolio growth rate ( R ), and call this P (r).  Let us assume that at the time of purchase, the stock has fallen so that it is discounted in price P (r).   In order for the cash invested in the new purchase to attain the portfolio ( R ), then the discount from P (r) at which the new stock must be purchased must equal the time the cash was held, in years, t (cash), multiplied by ( R ).  The illustration below shows this for a stock bought with cash that has been held for one year.

stock-discount-chart

For cash held for less than a year, then the discount from P (r) would need to be relatively less, while still enabling the stock to attain the same portfolio ( R ).  One source of error in purchasing stocks, especially volatile high growth stocks, is failing to patiently wait for an adequately low price.  In my proposed strategy of using accumulating cashed dividends to fund new stock purchases, the fact that the cash balance builds up slowly as dividends are contributed, is an incentive to wait for an adequately low price so as to generate returns at least equal to ( R ).  This is because frequently making small investments which use up the accumulating cash, if made at a discount to P (r) which is less than t (cash) times ( R ), will result in subpar long term returns.

There remains one question: if the stated goal of a rational policy of accumulating cashed dividends and reinvesting them, is to merely match the long term growth rate of the portfolio that would be attained if the dividends had been automatically reinvested in their respective stocks in the first place, then what is the point of hoarding the dividend cash in the first place?

The reason is as follows:  some stocks seem to have a higher expected growth rate because of the strength of their business and market expansion.  However once this is well recognized by the market, the stock in question becomes chronically highly priced, and is rarely available at an attractive price.  However, these stocks can yield great returns if they can indeed be found cheaply.  And, inevitably they sooner or later do fall in price.  In fact, when a company from which the market has high expectations (ADBE), meets a setback, it is generally swiftly punished and its stock falls more than would be the case for a company with a solid business but from whom the market has more conventional expectations (Philip Morris International).  This type of company might be termed a Volatile High Growth Stock. The above strategy of accumulating cashed dividends to take advantage of these infrequent opportunities can then in fact lead to overall increased returns.

Again the promise of higher returns by a high growth stock is only likely to be fulfilled if the purchase price is low enough.  On this inarguable basis,  a sound strategy might be to buy the target stock with half of the available cash when it reaches a % discount from the previous 52 week peak, that is equal to the 10 year growth rate for the portfolio ( R ).  Should the target stock fall to 2 x ( R ) from the same previous peak price, then the remainder of available cash will be invested in it.

This strategy may not be perfect, for example it may result in only half of the available cash being invested in the target stock at an attractive price. On the other hand, it preserves the chance for purchase of at least some of the target stock at the truly great price of a 30% discount to previous peak. This approach should at least preserve the average portfolio growth rate from damage caused by ill-advised purchases.  Meanwhile, If the target stock is one with growth rate relatively higher than the average for the portfolio, this should raise the portfolio performance.

 

Bought more ADBE in 2016; reflection upon the emotional aspect of the trade

On January 11, 2016 I sold 6.5% of my MSFT stake to buy ADBE.  I thus somewhat more than tripled my stake in ADBE, which nevertheless made up only 5% of my portfolio as of 12-31-2016.

The timing and pricing of this trade was as follows.  In August-September 2015 the market sold off by 10%, then recovered, only to sell of by approximately 12% in January 2016.  ADBE had bottomed on 8-24-2015 at 75, down 13% from its previous peak at 86 on 8-17-2015.  It then rose again to peak  at 95 on 12-29-2015 before falling 22% to nadir at 74 on 2-9-2016.

 I bought ADBE at 88 on 1-11-2016,  down less than 8% from the 12-29-2015 peak of 95.

In fact, since 1-11-2016 MSFT is up 20-83%, ADBE up 19.56% as of 1-18-2017.

But MSFT pays a dividend of 2.35% currently,  That trade isn’t looking too impressive. Bear in mind of course that the prices of both fluctuate, so on a different date, the assessment would be different.

Had I bought at the nadir of both stocks with MSFT at 75 and ADBE at 74 on 2-9-2016, since than ADBE up 46.24, MSFT up 26.89 not counting dividend, as of 1-18-2017.

adbe-msft-2016-chart

The rationale for the trade was that ADBE is a high PE stock with expectations of high future growth which have become well recognized by the market. This type of stock rarely trades at an attractive, relatively lower purchase price. I wanted to increase my holding of ADBE and wanted to take advantage of a lower price. I still agree with the decision to increase my holding of ADBE, but obviously I totally missed the true opportunity for a better price. 

This episodes proves again two timeless investing truths.  First, it is true that valuable and expensive stocks will be available at a better price, if you can only be patient.  Second, if you feel impelled to do something less you run out of time, just again, be patient. In fact using more time to decide will result in a better outcome.  This is not the only time that it would have been more profitable for me to wait for a better price.  In fact it is a recurring theme. 

But upon reflection, I find that this conventional lesson only probes one layer of this experience.  A distinct lesson is provided by considering the emotional aspects of the trade.

First, I felt I was missing out by not owning more of ADBE, a wonderful company with an insurmountable competitive advantage in its business (digital media) which it is strengthening, while building a second business (digital marketing) which looks likely also to have a sustainable competitive advantage.  This created a sense of urgency to trade.

Second, since I held no cash, I needed to sell another holding to buy more ADBE.  All of my 5 stocks are treasured holdings.  Part of holding such a concentrated portfolio is the nagging thought that perhaps I should be more diversified, at least within my 5 holdings.  This added to the anxiety surrounding the trade; on one hand, I should trade into ADBE, on the other hand, I was reluctant to sell my other holding.

the emotional aspects of investing must be explicitly embraced and addressed, rather than just suppressed.  Same as in the rest of life.  Remembering that good investing is a model for a fruitful life, lived to its fullest potential.

In perspective, the sum of money used for this trade was a very small proportion of my portfolio , less than 3%, as to make only a small difference at best.  This suggests that instinctive fear led me to avoid putting a healthy proportion of my portfolio on an investment.

Regarding strategies to reduce the roil of emotions interfering with sound trading next time.  One suggestion is to create a relatively fixed, preplanned trading strategy.

For instance,  wait until it is reduced 10% from the peak and use half of the money available for the sale.  Then use the rest when or if the 20% discount is reached.

This assumes that you really want to own the company.  If it is a new investment that may not have the same conviction as a better understood, long term holding, then waiting for the full 20% discount is probably best.

Second, in order to isolate the decision to purchase from the reluctance to sell a current holding, it would be helpful to have a source of cash for new purchases.  This is the topic of a subsequent post. 

The lesson to be learned from this episode is not just that patience is a virtue in investing.  For the barrier to patience is often posed by the emotions impelling a trade.  One cannot simply make one’s emotions disappear.  I for one, have been successful in making them disappear so far, and I am surely not alone. 

A better approach may be to 1. analyze the source of the emotions.  In my case, my rush to trade and poor decision making was not simply from a greedy rush to chase a hot stock.  By understanding the source of the feelings, you can know how to neutralize them.  2. have a strategy to avoid a repetition. For example, I will trade at specific target reductions in price, and not worry about trading until then, merely watching the market prices regularly.  I know my portfolio is sound as is, there is no urgency to trade unless it is actually at an attractive price.  3.  have a source of cash  for purchases.  Again, this point will be the subject of a different post.

In sum, the emotional aspects of investing must be explicitly embraced and addressed, rather than just suppressed.  Same as in the rest of life.  Remembering that good investing is a model for a fruitful life, lived to its fullest potential.

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Essential Criteria of an Amateur Investor investment.

edited 4-4-2016
1.  Sustainable Competitive advantage defending or growing market share in its specific market.  This is the sine qua non of our investment choices and the foundation of our approach to investment.  The company with a competitive advantage is rare.  It is marked by the ability to increasingly attain returns on investment above its cost of capital, and above those of its competitors.  A competitive advantage might be made durable by low cost/high volume leadership among competitors; barrier to market entry of competitors; product differentiation/switching costs to customers.  The company with a sustainable competitive advantage sells an indispensable product.

2. No competitive advantage truly lasts for ever. Hence, a related critical facet of the competitive advantage feature is that management consistently anticipates or reacts to changes in the market or competitive landscape by finding profitable ways of extending the company’s competitive advantage into new markets that are tangibly related to its current markets. That is, the company adapts and evolves to perpetuate its competitive advantage by extending it into the evolving new markets.

3.  Evidence of devotion to shareholders by its capital allocation, manifested in the following ways
stock buybacks to reduce share count
avoiding excessive dilutive stock compensation
obtaining good returns on investments in acquisitions
aligning reward and performance of management and employees to reward shareholders and long term company performance
allowing shareholders to have voting power commensurate with their stock ownership.

4  Common stock of publically traded company based in U.S. or other relatively transparent legal environment with respect for property rights, at least 10 years old.

5. The investment worthy activities of the business are demonstrated in the record of its past and present achievements, not in the hoped for future.

6.  quantitative evidence of ability to obtain returns on investment above cost of capital, such as low debt level, growing free cash flow, high free cash/revenue, high gross margin, high ROE and ROI.

2015 a year of realization, refocus, and anti-diversification

Amateurinvestor beat the market soundly in 2015. The 1 year return was 23.7%; 3 year: 22.1%; 5 year: 21.6% and 10 year: 15.3%. The S&P 1 year return in 2015 was -0.73%. As of 1-5-2016, S&P 3 year return was 11.2%, 5 year return: 9.58%, 10 year return: 4.70%. Therefore I have approximately doubled the S&P returns for 3, 5 and 10 years.

The relative proportions of my holdings are as follows:

MSFT 48.75%
CNI 4.6%
SBUX 19.7%
V 24.7%
ADBE 1.4%

The portfolio is rather focused, in fact the number of stocks dropped from 8 at the beginning of the year to only 5 stocks today. I would like to share some thoughts regarding my sale of 2 companies this year, Cerner (CERN) and Intuit (INTU). I sold these because I realized their purchase was a mistake.

I bought Cerner in October 2013 at $57.75. Cerner is the largest dedicated digital medical records software provider, has an impressive gross margin and a business with a high proportion of recurring revenue and switching costs. I bought it because it has an impressive record of growth for over 35 years. It provides a software platform is a critical part of its client’s business operations. It has staying power and seemed to have a durable competitive advantage. At the time I bought it, I owned just 6 stocks, which seemed to me to be very few, even for a focused portfolio. It seemed wise to diversify into a new strong company I had found. I had a few small doubts at time of purchase. At the time CERN had risen because of recent success in agreements to sell its software and services to major medical centers, particularly Intermountain Healthcare in Utah. I knew it was richly valued. In addition, it regular buys shares to compensate for share based compensation, but still manages to continually increase its share count, which casts doubt on its dedication to shareholder value. Unfortunately, events have shown that because of its high valuation, any miss in analysts’ earnings/revenue estimates are met with a drop in the stock price. There has been some loss of important customers to competitors recently which casts a little doubt on the invincibility of its moat. I decided to sell on August 10. At this point I was uncertain how well it would recover from the market instability of that time. Moreover, I was provoked by a quarterly revenue miss. Overvalued stocks with evidence of weakness in their franchise do not do well in market downturns. I sold at $65.40, at a modest gain, so the damage was limited. On Jan 6, 2016, CERN was at $57.9.

My error in this case was a failure to understand the Cerner business well enough either to a. be convinced that its earnings would continue to grow safely in spite of current overvaluation and related vulnerability to temporary downturns, or b. realize that it’s competitive advantage and dedication to shareholders were lacking and therefore not good enough to earn a place in my portfolio.

Underlying this mistake is a more fundamental and common error, that of impatience. I could have simply taken the necessary time to analyze the company before buying. Had I done so, CERN would have been available at a little less than $50 several months later in May 2014. In any case, the allocation at the time of purchase was approximately 0.8% of the portfolio, so the damage was bound to be limited. I cautiously limited my allocation because of my trepidation regarding valuation and other factors mentioned above. In fact, one might ask what was even the point of investing such a small amount in this company. To this I can only reply that I acted from intuition instead of analysis. The advantage of this is that it certainly limited the damage caused, while adding experience. The avoidance of serious mistakes is an important part of investing success.

Upon reflection, I note that I cautiously limited the size of my allocation, and also that I feel a needed a deeper understanding of the company, and that I could have been more patient. We will revisit these points later.

Intuit is an apparently attractive business, with a dominant share in small business accounting software, and market leading shares in retail DIY tax software and professional accountant tax software. As are Cerner, Microsoft (one of my favorite investments) Intuit was a survivor of the early 1980s boom in computing. As with Cerner, it seemed to be a judicious addition of a long lasting company with clear competitive advantages to my portfolio of so called eternal companies. I bought it in February 2015 at $91.00. It seemed somewhat overvalued but I attributed this to the well-established strength of its franchise. It has introduced Quickbooks Online, a cloud based version of its dominant Quickbooks small business accounting software. Other than Turbo tax, the market leading consumer tax software, the other anchor of its competitive advantage is (was) Quicken, software for home finance management.

In August 2015, again at a time of market turmoil, Intuit management made some capital allocation decisions which shook my confidence in their competence, namely the decision to divest Demandforce and Quicken. Intuit had acquired Demnandforce, an email marketing company for small businesses, in 2012 for $423.5 million. Intuit thought to integrate it with Quickbooks. 3 Years later, CEO Smith explained the abrupt decision to divest this recent acquisition made for over 10% of its 2012 revenue at the related investor presentation. He matter of factly stated that Demandforce and QuickBase [another business divested at the same time) are great businesses, but they do not support the QuickBooks Online Ecosystem and both serve customers that are up-market from our core small business customers.” When asked by an analyst to address Intuit’s record of acquisitions, he stated “many of the larger ones have not gone well”. “…We have a mixed record in terms of bolt-on businesses, new businesses that may not plug-in directly with QuickBooks or tax businesses…” and promised that management had developed a “set of criteria that [future acquisitions] have to meet”. In other words, he was promising that 32 years after its founding in 1983, Intuit would begin to ensure acquisitions make sense for the company before purchase. Obviously these words are not those of a CEO of an eternal company. Quicken was one of its original businesses at the founding and was providing over 20% of revenue in FY 2014. I was surprised by the decision to divest this instead of adapting it and continuing growth.

The poorly planned capital allocation into Demandforce and the abrupt divestiture of Quicken gave me the impression that Intuit management may not be able to adapt successfully to future markets. I had bought in February 2015 at $91.02 and sold in September at 89.26. I found it difficult to pinpoint where I went wrong here. Intuit seemed to be a sound and strong business, providing necessary products which had market leading shares. Perhaps if I had read more of the past financial reports, I would have discovered other episodes of poor acquisitions. Perhaps I should have simply observed its progress over enough time to get a more detailed impression of how it functions. Prior to its purchase, I had considered Intuit to be a strong business with an economic moat which was akin to those I owned. I actually sold shares in Visa and Starbucks, both of which were highly valued by conventional measures such as cash return, to buy Intuit. As happened with Cerner, I felt I lacked deep enough understanding of the company and its management, without which I was vulnerable to nasty surprises.

In the case of both Cerner and Intuit, I felt surprised by adverse company events, and retrenched back to my long term holdings. Therefore, 2015 was a year of realization, that buying companies which seem to be good businesses, and even to have a durable competitive advantage, is not enough. they must be observed to dominate their markets for the foreseeable future, and be observed to demonstrate management competence and respect for shareholders over some time, until one is convinced.

But how is one to judge when the evidence is enough to justify buying and holding forever? Sometimes the clue to a solution to a life problem can be found in a careful reflection upon the experience, and asking the question, “how did it make you feel”. This is because the correction solution is only correct if it is the right one for yourself. In the case of investing, as Benjamin Graham stated, “the investor’s chief problem, and even his worst enemy, is likely to be himself” (Intelligent Investor). The investor will need to be comfortable holding his security in the face of inevitable market fluctuations. In this case, as previously noted, I reflected that I did not feel I had a profound enough understanding of the company to feel comfortable holding in the face of a market downturn. The solution then is to wait and continue to analyze the company until I feel I know it well enough to be able to commit, or not. There are also cases of companies which are actually worthy, but seem overpriced, in which case one would wait for a market downturn even after having come to understand the company sufficiently.

This process of coming to understand the company is not purely intellectual. For example, I doubt a simple analysis of financial statements prepare one for Intuit CEO Smith’s rather absurd explanation of his failed acquisition of Demandforce. I believe rather than one must experience the company as much as is possible via its communications, perhaps its products, and by communicating when possible with clients, customers, employees. One must build a relationship with the company, until one feels one can trust it. This is actually what the legendary investor Philip Fisher (author of the book Common Stocks and Uncommon Profits) termed “scuttlebutt”, the flow of information he held indispensable for analyzing a growth stock.

Exploring a company which seems promising, and might rise in value, while waiting to feel fully comfortable enough to commit before buying, is difficult for two reasons. First, it requires patience. Inevitable, one is afraid of missing a low price. Second, it is surprisingly difficult to be motivated to really experience a company, to form a relationship with it, unless you have an interest in it. This may lie behind the investing approach of the excellent hedge fund ValueAct Capital. The investment staff study a company until it seems to be a good bet, then buy a small share and continue to follow it until they know it well enough to feel they know how it makes money, and what to expect from it. They then deepen the relationship by buying a stake large enough to command a board seat, and continue becoming part of it. Perhaps by buying a small stake in a company, I can be motivated to follow it closely enough to understand it better. Seen in the light of these thoughts, perhaps my cautious forays into new additions to my portfolio may not be faulted too much, but in fact be considered a necessary step to taking the time to come to know a company. And by limiting the size of initial investment, I limited the damage caused by errors. But the benefit is that this might be a way to actually discover new gems. Such was indeed the case with Adobe, a small investment I made which was turned out to be a wonderful investment.

Finally, 2015 was a year of anti-diversification, the acceptance that there are truly few companies which have exhibited the qualities of an eternal company in a lasting way, and acceptance that there is no need to diversity just for its own sake. In 2015 I sold Visa and Starbucks, which I had owned for years, and which I knew where companies with very strong franchises, to buy a new company, INTU, which I was less familiar with. Having corrected this error, my portfolio was whittled down to 5 companies. This time, I feel happy with the small number.

But again, reflecting upon this retrenchment back into my small collection of investment gems, I find that the high degree of comfort I have with my existing portfolio, continually reinforces the reluctance to invest in new companies. As my understanding of and satisfaction with my exclusive set of existing investments grows, this sets a higher bar for new companies to meet. And this may actually be an anti-diversification mechanism by which focus investing reinforces its own success.