Just read this book “The Big Money: Seven Steps to Picking Great Stocks and Finding Financial Security” by Frederick R. Kobrick.
Kobrick was an investment analyst at Wellington Management Company for many years before becoming a fund manager. The author has a website here.
The investment approach is to invest at the early stage (e.g. IPOs) in companies that can grow significant over many many years. The book emphasizes the importance of analysing the business model (especially whether a company has put in place processes to ensure repeatability of its successes) and the management behind a company, and stresses the need to constantly monitor metrics of a company to measure their performance to make sure that their execution continues to do well.
While the book goes into many examples of the qualitative aspects, and how each company trumped its competitors, it gives less clarity on the valuation aspects on how exactly to determine if the company is over- or under-valued, and does not mention how to calculate the intrinsic value of a company. The main valuation approach seems to be using ratios and comparing it with peers and historical figures.
This is one of the few books that made a good case for trying to identify great businesses when they are small, and holding them on for the long term. It quoted many successful business that had a huge run over 10-30 years.
One thing lacking that I think would be extremely useful is how position sizing is done, and how each position is slowly built over time. Another gripe is that many times the book can read like one of those ‘teaser pitches’ where it keeps repeating again and again that if you use BASM and his Seven Steps, you can be immensely rich, yet it does not clearly explain how exactly does it apply in the particular case. I suspect those teaser pitches are removed, the book can be shrunk by 1/3 to 1/2.
The Two Key Concepts
Analyse a company from four key perspectives – BASM:
- Business Model
- Does the company have control over its destiny? E.g. Coca-Cola and Nike are much more in control than Phelps Dodge.
- The business model should show what the company will do to become profitable, grow, and protect itself against competition.
- What does the company assume the market wants? What did it identify as the target market opportunity it wants to capture? Be as specific as possible, what is the product/service, what are the features and desired characteristics?
- E.g. Microsoft made an assumption that the market will want standard software. Molex (MOLX) assumed that electrical connectors will be used across tons of electronics.
- Circuit City spent on broad and deep inventory so that it can offer consumers more products at lower prices. Small retailers could not do that. It gave discounts on high-visibility, popular items to get consumers to visit the stores and potentially make other purchases.
- Microsoft locked in the relationship to ship their product with every IBM PC, then created office software that cemented their dominance through a network effect. Once you are entrenched, you don’t need the best product, just a competitive product. There were a lot more technically superior DOSes at that time.
- Dell pushed ahead in pricing (direct selling), distribution, service, technical support, understanding customers’ needs, which allowed it to come behind IBM and Compaq and overtake them despite their engineering expertise.
- Gap succeeded initially with rock-bottom prices, low number of items with wide range of size and colours, and replaced inventory quickly while holding on to styles that were selling strongly.
- Krispy Kreme Doughnuts failed when it expanded too fast and picked lousy locations. It also sold its donuts in supermarkets, gas stations, etc. which competed against its other sales channels.
- Great management can envision a great future and articulate a cohesive and logical strategy to get there. They can execute the details and want to win.
Seven steps to follow:
- Knowledge is the antidote to fear. Knowledge brings confidence, and confidence is what keeps people in stocks that are undergoing price pressures yet continue to have great growth in earnings. Confidence is what helps successful investors to buy more shares when prices dip.
- The great companies must be held over an extended period if investors wish to earn the big money. These companies grow over a period of years, not months. If you treat them like ordinary companies from which you get ordinary returns, you get ordinary returns.
- Market share gains and losses are core indicators to watch over a few years.
- If you love a company and really know it, you get many chances for great stock buys from the volatility of the stock market.
- Time horizon
- 3 – 5 years.
- Circuit City investors made 100X over 13 years (43% CAGR).
- Xerox investors made 40X in 12 years (36% CAGR).
- Molex investors made 185X in 33 years (17% CAGR).
- MacDonald’s investors made 800X in 30 years (25% CAGR).
- Coca-Cola investors made 68X in 18 years from 1982 (27% CAGR).
- Home Depot IPO investors made over 1,000X their money.
- Wal-Mart investors made almost 20,000X in 30 years (38% CAGR).
- Sun Microsystems IPO investors made 260X from 1986 to 2000.
- Market timing
- Write down what you anticipate for a growth rate, whether you agree with consensus estimates on future earnings, and the reasons.
- Write down the factors that would make you sell.
- Write down your sources of information to track the company (e.g. phone numbers of people, documents or publications, metrics used)
- Growth in sales, and growth in earnings that are better than those of their competitors. Market share growth.
- ROA, ROE.
- Gross profit margin, net profit margin.
- Same-store sales for retailers.
- Loan figures for banks.
- Traffic figures and load factors (seat miles filled by passengers vs. seat miles of capacity flown), Memorial Day traffic for airlines.
Execution is Key
- The specific technology a company sells can be less important than how the company manages the development and evolution of that technology, how it works with its customers, how it markets its products and services, and finally, how it manages itself.
- Think of technology as the ante is get into the game, think of BASM as the way those companies that win are able to do so. Good companies rank very highly on the four BASM factors.
- The most important aspect of high stock valuations is ‘repeatability’. If a company fails to carry their great product success forward and achieve repeatability, their investors lose money.
- Do not extrapolate by blindly using product cycles or historical trend, seriously think about what good stuff can really be repeated? What does the company need to do to repeat? What can change and go wrong?
- Examples of great execution
- Molex’s business model centered on working closely with customers in order to anticipate and meet or exceed their needs. This enabled Molex to be exceptionally good at designing what customers would want most. Molex had a very broad product line so that it can fill all needs and avoid being stuck in a niche.
- McDonald’s created and maintained a set of great operational systems that ensured consistency, quality, cleanliness, and low prices.
- Intel beats its competition which offered cheap clones, by spending significantly on R&D of production systems (not just on the product) to have minimum defects while churning out large numbers of chips quickly and at low costs.
- FedEx understood the two key factors are cost and reliability. The major cost in delivery is in the planes (e.g. capex, pilots, maintenance). By flying everything to one city, it cut costs significantly compared to point-to-point delivery. A central point also simplifies matters which mitigates delivery failures and improved reliability.
- My note: Execution should be evaluated under Business (Qualitative). A great company can result from having great business economics (e.g. toll bridge), having a great product (e.g. photocopiers vs. carbon paper), or having great execution (e.g. Molex, McDonald’s, Intel, FedEx) resulting in a great product.
- Do not invest in products, invest in the golden goose defined by BASM that creates both the product cycles and the earnings growth. Having a great product can be temporary if not coupled with great execution.
Metrics to Monitor Internet Companies
- Market share: Taking market share from similar companies, growing faster than competitors but not by doing things that are unsustainable.
- Mass: Enough size and presence and customers to be competitive. Around long enough to show that it can acquire new customers at a good pace and at an affordable cost.
- Model: A business model that shows the path to growth and profits very clearly.
- Momentum: A high growth rate, and one that is steady or accelerating.
- Management: Good.
- Scan companies to understand what they do and how they plan to succeed.
- For the most promising ones, go in depth and understand how the management intends to grow the company and do better than its competitors. Review all sources of information including news, publications, Wall Street, friends, employees, etc.
- Buy small positions with the most promising companies (even if they are competitors with one another). For those companies that execute well on their promises, add to the position. For those that don’t, weed them out.
- Keep track of key metrics for your companies and hold them as long as they are delivering.
- Keep close watch on IPO companies and follow their results, so that you can buy in early (at a low price) if they turn out to be great.
- Look at P/E using expected earnings, PEG using expected growth rates, P/S, P/B, growth in revenues, ROA, cash earnings over total assets, growth of BVPS, how the company is using its capital. Compare the figures with similar companies, and with the company’s own history.
- Look at how the stock trends with earnings by putting the quarterly earnings on the stock price chart.
- Avoid all companies that do not explain their earnings and accounting well enough.
- Ignore overall economic forecasts, but understand what things in the economy influence particular sectors and stocks. Kobrick had a funny imaginary radio report
- On Wall Street today, news of lower interest rates sent the stock market up, but then the expectation that these rates would be inflationary sent the market down, until the realization that lower rates might stimulate the sluggish economy pushed the market up again, before it ultimately went down on fears that an overheated economy would lead to a reimposition of higher interest rates.
Signs of a Huge Winner
- Taking market share from other worthy competitors.
- Having a huge or open-ended market opportunity.
- Knowing exactly how to lock in customers and work closely with them.
- Top guy is very competitive, has a vision and a strategy to achieve that vision to make it a long-term winner.
For some business models, it takes some time to know if it will work. Webvan’s business model of buying groceries online failed because the costs of delivery were beyond customers’ willingness to bear.
All three must be present
- Compelling valuations
- High earnings growth
- Management that can execute
Any of the following should trigger a sale
- Target price reached
- Even if great companies are temporarily overvalued, leeway should be given on the valuation sell discipline, since great companies often surprise on the upside with earnings and company performance.
- Change in management or strategy
- This does not apply when a stock is already down because of poor management and new management is brought in to turn things around.
- A change in management or strategy will require taking some time to see how they work out, after selling, can buy it back later it they are executing well.
- Failure to execute
- Need to ensure that mistakes are small. If you doubt that things are going well because the company is not executing well at the moment, sell. After you sell, watch the company (use metrics) and its stock’s performance carefully for a while to see if the company starts to recover. If it does, buy it back even if you have to pay above your selling price.
- Fraud or flagrant misrepresentation by management
What to Do When Stock Prices Tank Suddenly
The following are my own thoughts arising from Kobrick’s description of his team’s reaction during the 19 October 1987 Black Monday crash.
- Is this a correction or a crash? For crashes, most likely you would have known of it coming already (e.g. dot-com, credit crisis). For corrections, you have totally no idea why the market is reacting this way.
- For all companies that you own that are significantly overvalued, sell.
- For crashes, if it is a market-wide crash, sell out all positions;
- For crashes, if it is a sector-specific crash, sell out all positions in that sector. Assess the knock-on impact on the other companies you own. For those that would be significantly affected, sell them as well.
- For corrections, do not add immediately. The shock will take a few days to play out. Gradually add to your positions then, depending on how undervalued each position is.
- For crashes, use Anthony Bolton’s pointers on market timing in terms of when to buy in.
- American Airlines – In 1972, after reviewing management’s assumptions, found that earnings estimates were far below what great brokerage analysts had. Resulted in Wellington selling off their airline positions at a high before they crashed (stock went from $49 to $6).
- DeKalb AgResearch – Analysts thought hybrid seeds companies will not grow because farmers are very conservative, slow to adopt new things, put off by the higher price of hybrid seeds, and fear that seeds will not work and ruin their harvest. Kobrick found that the price of seeds is less than 1% of total production costs; DeKalb had management that understood farmers’ concerns, created test fields of corn, and educated the farmer. He also confirmed that DeKalb’s efforts were working through conversations with agricultural suppliers and farmers. Made 400% on the stock.
- Sun Microsystems – Sun beat Apollo through its open architecture approach. Read Sun’s strategy in the original offering prospectus and spoke with Scott McNealy.
- Pacific Sunwear – Management tested designs and stayed close to customers and what they wanted. Made 35X in 5 years.
- Upjohn – Developed minoxidil (Rogaine) for hair loss. Kobrick assumed that it will work on one-third of people and bought the stock. Doubled in months.
- Radio Shack – Started to sell PCs with salespeople that go to small businesses. Stock doubled. Later on got killed by Dell because prices were not competitive with the sales commission.
- Cintas – Supplied uniforms. Had fail-safe systems to ensure delivery schedules, replacements, cleaning, etc., which turns out to be very hard for other companies to do.
- U.S. Surgical – Pioneered laparoscopy for gallbladder surgery. Up 15X in 2 years. Sold the stock due to lack of future product line and overvaluation, before it crashed.
- Bear markets
- 1847 – British railway mania crashed in October 17, 1847.
- 1973 – “Nifty Fifty” mania.
- 1983 – Tech boom and bust
- 1987 – crash
- 1990 – Big stock market decline as the economy went into recession.
- 1992 – Correction in NASDAQ
- 1994 – Inflation and tightening
- 1997 – Asian crisis (debt)
- Jan 97 – Hanbo Steel collapsed under $6bn of debt.
- Feb 97 – Somprasong Land Public (Thai) missed foreign debt payments.
- May 97 – Thai baht hit by speculative attacks to devalue the baht. Thailand failed to defend the baht, and was force to float it in Jul 97. Finance One (largest Thai finance company) failed.
- May – Oct – Asian currencies fell. Taiwanese dollar devalued. HK market beaten up. U.S. market continued to go up.
- 24 Oct 97 – DJIA fell 7.18%. Dell dropped from $100 to $73 in days. Yahoo dropped from $53 to $38 in 3 days.
- Mar 98 – U.S. stocks more than recovered.
- 1998 – Russian debt crisis. LTCM.
- Aug 98 – News and analysts talked about a bear market. Russia devalued the ruble and defaulted on its debt. DJIA fell 357 points.
- Sep 98 – Merril Lynch’s stock dropped 50%.
- Dec 98 – Stocks more than recovered.
- 2000 – Tech and telecoms capital spending bubble
- 2001 – September 11, 2001.
- Factors that cause bear markets
- Persistent overvaluation
- High or rising interest rates or rising inflation that leads to them
- Weakness in company earnings
- Oil shocks
- Wars (but not always)
- Most big acquisitions fail, particularly in technology, and they are mostly done when management runs out of innovations and good growth ideas.