The Education Of An Investor

It takes a man a long time to learn all the lessons of all his mistakes – Jesse Livermore

It must be noted that your Chairman, always a quick study, required only 20 years to recognize how important it was to buy good businesses. In the interim, I searched for “bargains” – and had the misfortune to find some. My punishment was an education in the economics of short-line farm implement manufacturers, third-place department stores, and New England textile manufacturers – Warren Buffett, 1987 Letter to Shareholders

Stocks – like ex-girlfriends – teach you lessons if you pay attention. In this blog, I’m going to tell you the story of four stocks and two mutual funds I once loved and how they taught me everything you need to know about successful investing. It’s not Romeo and Juliet but it could make you a lot of money.

The story starts in June 1995 when I graduated from Menlo High School in Atherton, CA. As a graduation gift, my parents gave me $1500 of a stock called EMC that their broker recommended. EMC – now a part of Dell (DELL) – makes data storage hardware. In 2004, it acquired VMware, now a part of Broadcom (AVGO). By early 2000, I was working as an intern to a broker at Morgan Stanley and my EMC stock was worth ~$20,000. I was also taking a Finance class in my 5th year at UC – San Diego.

Around that time I read an article by the Economist George Reisman about how tech stocks were in a bubble. Reisman was a disciple of the Philosopher Ayn Rand and the Austrian Economist Ludwig von Mises and I had purchased his ~1000 page tome Capitalism. Combining what Reisman said with what I was learning in my Finance class, I sold my EMC stock and bought the Vanguard Total Stock Market Index mutual fund.

Since the market was almost perfectly efficient according to academic finance, nobody could beat it and the best you could do was buy an index containing a broad basket of stocks. In the subsequent Dot Com Bust, EMC lost 90% of its value while the Vanguard Total Stock Market Index fund lost 50%. In 2016, DELL acquired EMC for $67 billion. The Vanguard Total Stock Market Index fund has done just fine since I bought it in February 2000 as well. Either way, had I held on I would have made a lot of money.

When I graduated from UC – San Diego in June 2000, I went to work for an consulting firm called Economic Analysis LLC in Century City (West Los Angeles). My Dad helped me find an apartment in Westwood and my parents took me out to dinner at the nearby Cheesecake Factory (CAKE). Having a taste for heavy food which I still retain to my Mother’s dismay (no vegetables for Top Gun, Thank You), I thought it was great. When I found out it was a publicly traded company, I bought the stock. Had I held on to the stock, I would have done just fine.

I quit Economic Analysis in mid-July 2002 to enter the Philosophy Phd program at UC – Davis in the Fall of 2003. In the meantime, I had some time on my hands so I moved to Malibu, delivered pizzas and discovered Value Investing. That led me to Mason Hawkins Longleaf Partners Fund. On the spectrum of value investing, Hawkins leans more Ben Graham than I currently do but he’s a solid, disciplined investor and I learned a lot reading his quarterly commentaries for the fund. Once again, had I held on to the Partners Fund I would have done just fine.

About a year into the Philosophy Phd program I realized that the housing market was in an unsustainable bubble. The more I read and learned, the more convinced I became that the bust was going to be epic. Ultimately, I decided to drop out of the Phd program and start Top Gun to profit from the carnage.

I went live at the beginning of 2007 and wrote a short essay titled “Are You Prepared For The Coming Recession?” which I offered to all the residents of Granite Bay, CA (a wealthy suburb of Sacramento) via a postcard in exchange for their email address. Sure enough, the housing market started to implode in the latter half of the year and my shorts in the leading homebuilders, investment banks and mortgage lenders paid off in 2008 when I returned 15% compared to a 38% decline for the S&P 500. It’s nice to make money but it’s even nicer to make money when everybody else is losing their shirt.

I thought I was a genius. I didn’t realize that I was mostly young and had a lot to learn. I stayed bearish too long and all the money that had flowed in during 2008 and 2009 flowed out as I underperformed. If you look at a long term chart of the S&P 500, The Great Recession – which seemed like the end of the world at the time – is just a blip.

Fast forward to 2017. I fell in love – twice. With Kroger (KR) and Teva (TEVA). (I’m a romantic at heart. What can I say?). I bought them both for the wrong reason: they looked cheap on a Price-to-Earnings (P/E) basis.

When Amazon acquired Whole Foods on June 16, 2017, investors assumed Amazon was about to eat Kroger’s lunch. With KR trading around 10x earnings, I decided to take the opposite position. For once, I held on to the stock and while KR continues to trade for about 10x earnings, I’ve done just fine – because its earnings have compounded. TEVA didn’t work out as well because it’s earnings haven’t grown. It turns out it was cheap for good reason.

Why did KR work out while TEVA fizzled? They were both cheap on a Price-to-Earnings basis. KR worked because it was a decent business that continued to compound earnings over the years as Whole Foods never threatened it the way the market feared it would at the time. KR earned $2.11/share in 2018. A month ago it guided 2025 EPS to $4.60-$4.80. TEVA earned $2.92/share in 2018. A month ago, it guided 2025 EPS to $2.45-$2.65. In other words, it’s going to make about the same this year as it did 7 years ago. Therefore, it’s no surprise the stock price is about the same.

There’s a lesson here: What matters most is not that a stock is cheap but that it can compound earnings for years into the future. As earnings compound, the stock price goes up even if the multiple doesn’t. (And frequently the multiple expands as well as the market recognizes a high quality compounder). If earnings don’t compound, the stock price has no reason to go up – as TEVA’s hasn’t.

“What light through yonder window breaks? It is the east and Juliet is the sun!” It’s a beautiful line but where did it get Romeo in the end? With all due respect to Shakespeare, I would have had him say something like: “Thou value is all on the surface but within you lack quality – and therefore the ability to compound earnings over time.” Like I said, I’m a romantic at heart.

You can draw lines on charts or try to forecast macro cycles. I’m not saying you can’t make money that way. But the proven strategy for making money in the market is simply to buy quality companies that can compound earnings over time. Even if you pay a high price, you will generally do fine as the earnings catch up with the stock price. There is an abundance of companies that trade on the stock market that meet this criteria. Some will do better than others but most will do fine over the long term.