2. 2
Alligator Investing’s Mission
Alligator Investing’s mission is to provide investors with a basic, common-sense
knowledge to approach investing in stocks, and to enable them to acquire long-term
wealth at a controlled level of risk.
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INTRODUCTION
For over the past two decades, I have spent my career analyzing businesses. I started as
an auditor in public accounting, spending a good deal of time picking apart many types of
businesses. Some were successful; others were not. It was interesting seeing different
companies and gaining an understanding of not just business, but why some companies
thrived while others failed. I also gained a further appreciation of accounting, not just as
a reporting mechanism, but also as a tool used by a company’s management to assist
them in evaluating business decisions and in measuring the success of those decisions. It
was also a valuable experience to interact with the various company management teams.
How well did they understand their markets? How focused were they on exploiting their
opportunities? How responsive were they to changes in the business climate? How good
were they at deploying company resources in order to maximize their profit potential?
Generally, the better the management team was at addressing those questions, the more
success the company achieved.
I left public accounting to pursue a career in investing, spending the last fifteen years
analyzing stocks and managing equity portfolios. Portfolio management further
enhanced my understanding and appreciation of accounting, finance and economics, and
how they are invaluable tools to the wealth building endeavor of investing. While that
may not seem like a long period, the past fifteen years have been quite dynamic. During
this period, the stock market experienced the greatest bull market since the roaring
twenties, and the largest bear market since the great depression. The market had to cope
with fears of both inflation and deflation, a rising and falling U.S. dollar, a war on
terrorism, as well as the inflating and bursting of the technology bubble that triggered at
business recession. This period also witnessed the collapse of Long-Term Capital
Management, a hedge fund run by Nobel Prize winning economists. The market was
shaken by some of the largest corporate frauds and scandals ever seen, including Enron,
Tyco, and WorldCom. Once formerly respected moguls of business were sent to prison
for longer terms than many murderers receive. Now the United States is sorting through
a housing bubble and a subprime debt and banking credit crisis; the worst debt crisis
since the junk bond debacle of the 1980’s. The jury is still out on how these problems
will be resolved, but rest assured that they will.
The U.S. stock market has survived two world wars, the Great Depression, the 1970’s oil
embargo, multiple recessions, and it will continue to survive anything the world can
throw at it. Not only has it survived, the stock market has thrived. Over the twentieth
century, the U.S. stock market returned 10.3 % to investors. One thousand dollars
invested in 1900 would have grown to over eighteen million dollars by the turn of the
twenty-first century. Despite getting off to a slow start, this century should be equally
rewarding.
The investor’s job is to participate in the stock market and to maximize opportunities
without taking unreasonable risks. Investors don’t need to be certified public
accountants, financial analysts or have a masters degree in mathematics, but they do need
some basic math skills (six grade math is sufficient), common sense, and some guidelines
4. 4
to follow. They also need to spend some time monitoring their investments and
investment programs. Ultimately, every individual is responsible for his/her retirement
savings. If you are one of the lucky few to have a corporate or government sponsored
pension, that’s great! But that still may not be enough. Should anyone strictly rely on a
corporate pension? Look what happened to the unfortunate flight attendants when the
airlines filed for bankruptcy, or to the partners at Arthur Anderson & Company who lost
everything when a lawsuit put them out of business, or the employees at Enron who had
all their savings in Enron stock, just to see it disappear. Investing is a certainly not a
riskless proposition, but by spending just a little time, anyone can make sound investment
decisions. If you prefer to use an advisor to handle your retirement program, effort is still
required to assure you are getting good advice. Use a policy of “Trust with Verification.”
Not all advisors have their client’s best interest in mind. Many advisors are pushing
overpriced products that they are told to sell by their employers. If you are not getting
value for your money, then you are losing not only the fees you are paying, but also the
lost returns from being in an inferior investment program. Chapter 3 illustrates how just
small changes in annual returns have huge impacts on future savings.
Investors today have a big advantage over those of 100 years ago. That advantage is
access. It has only been in the last few decades that stock investing has become more
accessible by the general public. Over a hundred years ago, the stock market was
considered primarily for the privileged and wealthy. Information was not readily
available on public companies. Indeed, regular quarterly and annual public financial
filings were not even required until the Securities Act of 1934. Brokers were people who
barely qualified as professionals and were not necessarily considered the trust worthiest
people. Commission rates were exorbitant and kept small investors out of the market as
the trading costs were prohibitive. Regulation of the industry was also in its infancy and
risk controls were inadequate. Mutual funds were invented in the early 1920’s and were
embraced by middle-class families even back then, but it wasn’t until the Investment
Company Act of 1940 that disclosure rules and requirements were better defined.
The age of technology brought investing to the masses. The automation of formerly
manual processes reduced the cost of investing. Additionally as technology prices
continued to decline and computing power steadily improved, the cost of investing
declined in lock step. The reduction in costs means that investors get to keep more of
their money versus paying it to brokerage firms for commissions and account fees. Prior
to 1990, it was not uncommon for brokers to charge rates of 50 cents a share or more,
plus minimum trade charges of $75 or more if they couldn’t trade enough shares. Not
only that, you had to talk to a broker! Charles Schwab was one of the original discount
brokerage pioneers who recognized that many (if not most) brokers were nothing more
than order takers and added little value (if any) to their client’s investment needs. With
that in mind, he used technology as a platform to offer discounted brokerage to the
general public. Although advice is not a commodity, trading is. And to charge extra for
mere trade execution made no sense to him. The public agreed, and today Charles
Schwab and Co. remains one of the premier discount brokerage firms.
5. 5
Today, the individual investor can trade 1,000 shares or more at a time for less than ten
dollars per trade. Ten dollars may not seem like much, but it adds up to a small fortune
over time. Assume the average investor makes two trades a month … one buy and one
sell. Assuming the commission savings per trade is fifty dollars, that would amount to
$1,200 per year. Investing that $1,200 into the stock market over twenty years at an
average return of ten percent would compound to $68,730. Thank technological
advancement for making these savings possible.
The other main benefit that technology has brought is access to information. This rapidly
accelerated with the spread of the Internet. Prior to the Securities Act of 1934,
companies whose stock traded in the public market were not required to make annual 10-
K and quarterly 10-Q filings. Even after this requirement, the individual investor had to
call the company to request a copy of the filings. Other news could be obtained from
reading the daily newspaper, magazines, or other traditional sources most of which
required a subscription. The Internet has changed the landscape dramatically.
Information today is vastly more abundant and only a mouse click away. Not only are
the required regulatory filings available online, recent news and events are available and
sorted by company. Sifting through the Wall Street Journal or other publications to find
information is no longer necessary. Simply go online and search for company news at
one of many financial websites. Much of the information the individual investor had to
pay for can now be obtained for free, such as earnings estimates and changes in
estimates. The passing of fair disclosure requirements by Congress in 2002 also means
that public companies who host quarterly earnings conference calls and investor days for
professional analysts must make these events available to the general public. For the
price of a broadband Internet connection, anyone can now participate from the privacy of
their own home. If a person can’t listen live because they are busy at work, on vacation,
or otherwise occupied, don’t worry. Most of these calls are available for replay at the
investor’s convenience. Thanks to technology, it has never been so easy to get
investment information, and the situation is more than likely to keep improving.
Although mutual funds and ETF’s (exchanged traded funds) have been around for
decades, technology has also greatly benefited these investment instruments. Again, the
processing and trading costs involved to manage mutual funds has declined. These lower
costs get passed down to investors in the form of lower fees. In the case of index funds
(funds that simply mirror popular indexes such as the Standard & Poor’s 500 Index),
costs are even lower because an index fund does not have to pay the expensive research
staff salaries and bonuses that actively managed funds pay. Not only that, but most
actively managed funds perform worse than the index they are trying to beat. That brings
us back to the information benefit. Today an investor who wants to know how their
actively managed mutual fund is performing can simply go online and compare the
fund’s performance to the benchmark index and a group of funds that are similar in style.
The investor can also keep track of changes in portfolio managers, get updates on current
holdings and changes in holdings, as well as other important information on the fund.
So what is the point of Alligator Investing? It is simply that investing should not be a
mystery or an unwanted chore, but an everyday part of life. It is a common sense
6. 6
approach to investing for the long-term that is rooted in sound principals and concepts.
Its objective is to help the individual investor increase real wealth over time. Keep in
mind that stocks will periodically decline as part of the normal investing cycle; but as
time progresses, the risk of losing money diminishes. Alligator Investing can be applied
to investing in individual stocks, mutual funds and ETFs. The chapters that follow will
detail the fundamentals of Alligator Investing and their application to investment
programs.
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CHAPTER 1: THE WAY OF THE ALLIGATOR
What do alligators have to with investing in public companies? Stepping back and
comparing alligators with companies helps discover that they actually have quite a bit in
common. Both alligators and companies have to function within their environments. For
alligators it is the swamp; and for companies, it is the economy. Both are fighting for
survival as they struggle to dominate their territories. They compete against others for
resources. Alligators are competing with other alligators as well as competing against
other species for food, water, shelter and the right to mate. Companies are competing
with direct competitors and other unrelated businesses for customers, suppliers, raw
materials, labor, manufacturing and office space, distribution capabilities and other vital
resources to sustain themselves; and also the right to mate … or in this cage merge in
order to broaden their business base and capabilities.
The business environment also has commonality with the swamp. Both are fertile
ecosystems providing the necessary elements for survival. But they also provide
challenges. Changes in the weather, drought, disease, predators and other perils must be
overcome as the alligator struggles to become dominant in the territory. The business
climate is also volatile. A rising company must navigate through recessions which
reduce the available resources needed to thrive. It must fight off competition, regulation,
labor shortages, and countless other issues on its way to dominating its industry niche.
In a capitalistic business system, companies are predators, just as alligators are predators
of the swamp. It’s Darwin at its best, as only the strongest and the fittest will survive and
become the “alpha males” of their respective territories. But the struggle for survival and
dominance will be ongoing, because there will always be the threat of a new emerging
alligator with the ambition to take over the swamp.
The Alligator Lifecycle
Companies follow a lifecycle that is similar to that of alligators. Prior to birth, alligators
start in the nest where many eggs have been gently placed and provided the nutrients and
protection to hatch as baby alligators. These eggs are analogous to venture capital
backed businesses. These businesses start with an idea and very few resources. Venture
capital or “Angel” financiers provide the nutrients and shelter to fledging companies.
The fledglings will emerge from the nest as small capitalization (“small-cap”) companies.
This book will not be concerned with venture capital backed companies because they are
typically privately held and not traded in the public market. Our journey through the
swamp begins with the infant alligator … the small-cap company.
Baby alligators are numerous when they hatch from the nest. However, the hatchlings
are not the dominant predators that they will eventually become. At this stage in their
lives, they are quite fragile and may fall victim to a host of troubles. Some will starve.
Others will contract diseases and perish. Still others will become food for birds, snakes
and other larger alligators. While infant alligators are fast growing as they journey
towards adolescence, it is a rough road and many of them will not survive.
8. 8
It is the same situation for small-cap companies. They are abundant in number. As of
year-end 2007, about 300 U.S. companies with market capitalizations over $15 billion (a
reasonable cut-off for large-caps) traded in the public markets, but over 4,500 companies
were available to trade with market caps below $1.5 billion, the small-cap breakpoint.
The small-cap arena is where many fast-growing, emerging companies can be found. But
it is also where most companies fail. Small-cap is a risky stage in a company’s life.
They have yet to acquire a base of business that will carry them through recession.
Companies fail as a result of gross mismanagement. Stronger competition takes note of
the emerging company and crushes it through predatory pricing or other tactics. Many
small-cap companies are not yet profitable and will fail due to lack of sustainable
financing. Many potentially innovative products don’t gain consumer support and fade
away. In fact, 14 percent of the companies traded today in the Russell 2000 Small-cap
index were unprofitable, a key indication that they are not yet self-sustaining. To put it
another away, about one out of every seven small-cap stocks is a sick or starving baby
alligator.
Adolescent alligators have one main thing in common with baby alligators, and one main
difference. The main consistency between adolescents and infants is that they are both
growing fast. Infants can easily grow more quickly because they are growing from a very
small size, and for a certain period of time can live off their fat reserves. During
adolescence the alligator still grows quickly due to its gain in stature and ability to more
readily fend for itself. That leads us to the main difference between infants and
adolescence. At adolescence, the alligator has now become more of a predator versus
prey. Its increased size has made it a more formidable animal to be reckoned with. The
adolescent alligator has gained in experience and become an expert hunter, established its
shelter, and learned to avoid many of the swamp’s hazards. Although it must still
compete against the adults in the territory, the adolescent alligator’s survival is practically
assured at this point.
Midcap sized companies are the business world’s adolescents. Ranging in size from $1.5
billion to $15 billion, there are just over 1,000 in number to choose from. These are the
companies that have emerged from the small-cap stage and now have their sites on
becoming industry dominators. Like small-cap companies, midcaps are fast growing.
Using the Standard & Poor’s Small-cap and Midcap indexes for comparison, the earnings
growth for stocks in these indexes for the past 15 years was about 14 percent and 13 ½
percent, respectively. Midcap companies continue to emerge after building a solid base
of business from which to grow. At this stage, they have the resources to bring in more
experienced management teams who know how to exploit large market opportunities.
Midcaps can invest more in sales and marketing, research and development,
manufacturing and distribution infrastructure. Their products and services are becoming
more recognized by potential customers. This often results in an acceleration of the
demand curve company’s offerings. The small-cap stage is where “early adopters” test
new products such as cellular phones, satellite television, new cholesterol drugs,
innovative athletic shoes, etc. But it is in the midcap space where products go
mainstream and really take off.
9. 9
Like the alligator, midcap companies also are more resilient and much less prone to
failure. Only 4 percent of companies in the Russell Midcap index were unprofitable in
2007 … meaning 1 of 25 were in jeopardy, making midcaps one-third the risk versus
small-caps. This is because midcap companies have built up a sufficient base of business
to carry them through tough economic times when they occur. Their management teams
are seasoned professionals who are experienced in effectively deploying the business’
capital resources. Midcaps have successfully fended off the competition from both their
peers and against larger companies in their industries. At this stage, their survival is also
practically assured.
This brings us to the adult alligator. The adult alligator is master of his territory. He
dominates in stature and has very few, if any, predatory threats. He may still grow, but
growth will be slower because he is now mature. His biggest day-to-day challenge is
finding enough to eat in order to sustain himself. His biggest threat to survival is not
from other alligators, but rather from habitat destruction. If the swamp dries up, he will
perish unless he moves to more fertile ground. Large-cap companies are just like adult
alligators. They are fewer in number and dominate market share within their industry
niche. Large-caps grow slower than small and midcap size companies. They have fewer
competitive threats, and the primary reason for their downfall is typically the decline of
their industry.
Let’s examine large-cap characteristics a little deeper. There are only about 300 large-
cap companies in the United States compared to thousands of smaller companies. There
is a logical reason for this. First of all, there are only so many large industry
opportunities. What do people use and need in everyday living? … Housing,
automobiles, telephones, computers, clothing, food, gasoline, air travel, movies, etc.
When you break it down into major components, there are only so many big product and
service categories that people need. Within each of those needs, one common theme
exists. Everyone wants to get the highest possible quality at the lowest possible cost! Or
in the case of luxury items, everyone wants exclusivity and will pay handsomely for that
special privilege. Because of this, industries consolidate down from many participants to
just a few leaders. After all, there can only be one “low-cost-producer” or “premium
brand.” At the infancy stage of the automobile industry, dozens of manufactures were
vying for market share. Only a handful survive today. When the computer industry was
emerging, hundreds of small computer assemblers and manufactures existed. Only a
handful survive today. It is the same case in the oil industry, the beverage industry, the
household appliance industry, the athletic shoe industry, and so on. Natural evolution
dictates for all industries that they will consolidate down to a few leaders.
What causes some companies to become dominant while others struggle to survive? The
key differentiator is management. Sure the industry leader has the lowest cost
production, the best distribution, a formidable sales force, and a solid capability in
research and development. Much of this is taken for granted, but it is a monumental task
for a company to obtain these advantages, let alone continue to build upon them. Why is
Intel able to dominate everybody else in the microprocessor business? Why are Coke
10. 10
Cola and Pepsi basically the only two brands of cola that people commonly recognize?
How did it come about that Exxon, Proctor & Gamble, Boeing, Microsoft, Nike, Toyota,
Johnson & Johnson, Kellogg, Wal-Mart, Starbucks, Nokia, and other industry leaders
beat out their rivals? The simple reason is because they had the better management teams
who knew how and where to focus company resources. The leaders effectively invested
in infrastructure … not just physical but also in human talent infrastructure. They
nourished cultures for success and were careful not to become complacent and allow
another hungrier competitor to take away their customers. Focused managements who
are motivated and remain hungry for success is a key characteristic in all today’s industry
leading companies.
Large companies grow slower than small and midcap companies. Over the past fifteen
years, companies in the S&P 500 index grew their earnings at a 10% annual rate, over
three percent slower than the small and midcap indexes. The natural progression is that
growth slows during a company’s adult stage. As a company grows, it becomes a bigger
part of its industry, making market share gains more difficult. In adolescence, a company
may only have a 15 percent market share, leaving an 85 percent opportunity for further
market share gain. But as an adult and having achieved a market share of 50 percent or
more, the company has less opportunity than before to grow at the expense of its
competitors. The large-cap leader becomes more dependent upon industry growth to
sustain its own growth trajectory. Forty years ago, Nike was a new entrant in the athletic
footwear industry with barely a single point of market share. For years, it grew rapidly as
its products became more popular with consumers. Today Nike is the industry leader
with the dominant market share. Further market share gains are more difficult because
Reebok, Adidas (the former leader) and others have become better run companies in
order to compete against Nike. Today, Nike’s growth is slower than before and more in
line with industry growth. To keep growing, Nike has entered adjacent industries like
apparel and sports equipment. Today, Nike is an adult alligator in search of enough to eat
to sustain what little growth it can.
The second reason that growth is slower for large companies is because industry growth
itself slows over time. Industries begin with “early adopters” purchasing their product or
service. If the product gains broad appeal, prices generally decline making it affordable
for the masses. As it penetrates into the masses, industry growth accelerates. Often this
accompanies the adolescent phase of companies participating within that particular
industry. Eventually, over half of the people who eventually want the product have it,
and the industry enters its maturity stage accompanied with slower growth. A hundred
years ago, automobiles were a luxury item and status symbol. Despite the fact that they
still had to travel mainly on dirt roads, people wanted them and could see this was the
future of transportation. Henry Ford brought the automobile to the masses and the
automobile industry flourished for decades as the number of households with a car in the
garage continued to increase. Today, just about everyone in the United States has a car
and the bulk of industry sales are mainly to replace older worn-out cars.
It is not easy to destroy an industry dominator. The most common cause is that its
business becomes obsolete (habitat destruction) due to some newer innovation taking its
11. 11
place. The automobile killed off the horse-drawn carriage. The typewriter was replaced
by the personal computer. One-hour photo shops and digital photography did away with
Polaroid. Gross mismanagement is the other main cause for the demise of large
corporations. Every once in a while, a company gets too big for its britches and
management overreaches their capabilities. They become overconfident due to past
successes and begins to make a series of poor decisions as they try to maintain an
unsustainable level of growth. Recent examples of overreaching include Enron
Corporation and WorldCom. But large business failures are the exception, not the rule.
In general, after a company becomes dominant in its industry, it tends to grow more
slowly and merge with other competitors, making itself even more dominant than before.
And so goes the alligator’s lifecycle. Rapid growth during infancy accompanied with a
high survival risk. Continued rapid growth throughout adolescence at a lower level of
survival risk; followed by slower growth during adulthood when it achieves dominance.
Keep in mind that all adult alligators and all large-cap dominant mature companies have
one thing in common: They all had to pass through adolescence.
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CHAPTER 2: WHY STOCKS MOVE
History has shown that stocks rise over the long-term, but what causes stocks to rise and
fall? Simply put, the primary reason stocks rise and fall is because of the change in their
earnings-per-share. If earnings-per-share are rising and the expectation is for earnings-
per-share to continue rising, then stocks will go higher. If earnings-per-share are
declining and future earnings-per-share are expected to continue to decline, then stocks
will go lower. There is a strong link between the direction of earnings and stocks over
long periods of time.
Over short periods of time stocks are more volatile. In any given year, stocks may rally,
suffer a correction, and then rally again despite the earnings path remaining stable. That
is because investors as a group are an emotional bunch. And when money is involved,
emotions are heightened. The powers of greed and fear take over. For example, earnings
are rising. Companies are beating estimates. The economy is good and jobs are plentiful.
Stocks are going up and people don’t want to miss out. After all, it is fun to make
money. So they buy and they keep buying. The hot stocks get more buying attention.
Everyone wants to be winner and share his or her success stories at cocktail hour. It is at
these times that stocks approach the high end of their valuation ranges. Investors as a
group have become greedy and more willing to accept more risk. Don’t forget … stocks
are risky business.
And then it happens. Maybe a leading company gave a poor outlook. The job market is
not as robust. Inflation is coming back. Maybe earnings weren’t good enough to beat
Wall Street’s infamous “whisper number.” The Federal Reserve raised interest rates.
Whatever the problem is, stocks aren’t going up anymore. Even worse is that they are
going down! People who bought at the top want to cut their losses, so they are selling.
People want to pocket their gains before they disappear, so they are selling. You don’t
want to be broke at cocktail hour. It is not as good a story to tell. On top of that, it’s no
fun losing money … so people are selling. Fear has overtaken greed. It is at these times
that stocks approach the lower end of their valuation ranges, setting the stock market up
for the next rally.
The battle between greed and fear will rage on, but that is a short-term issue. Over the
long-term, it is earnings-per-share that matters; and more specifically, it is the direction
of earnings-per-share that matters. Line up any stock index against its earnings-per-share
and you will see that stock prices and earnings are closely correlated. Figure 1
graphically illustrates the relationship between price and earnings for the S&P 500 index
over the past 50 years. You can see that the S&P 500 has risen in value along with the
growth in its earnings. A regression analysis between the S&P 500’s price and earnings
since inception shows that earnings per share has explained over 90 percent of the S&P
500’s price action over the long-term.
But over shorter periods of time the relationship between price and earnings can break
down. During much of the 1970s and 1980s, the S&P 500 traded below its earnings trend
13. 13
line due to high interest rate levels and ongoing concerns over inflation, recession and the
United States’ competitiveness (or lack thereof) in the global economy. During the late
1980’s and 1990s, a combination of declining interest rates and euphoria about the
resurgence of the U.S. economy, and a new era of technology drove the S&P 500 far
above its earnings trend line to unsustainable valuation levels. During the first part of
this decade, stocks returned to more normalized valuations when the technology bubble
burst. At that point, fear became the overriding emotion and returned the S&P 500 back
to its earnings trend line.
Figure 1. S&P 500 Price and Earnings Over Time
S&P 500 Price vs. Earnings
$0
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1957 1967 1977 1987 1997 2007
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Price
EPS
Although earnings explain over 90 percent of stock price movements over time, it
becomes less of an influence over shorter time horizons. For example, earnings on
average explain 80 percent of price movements over 30-year time horizons, 70 percent
over 20 years, and just 50 percent over 10-year time periods.
Clearly other forces come into play that influence the short-term direction of stock prices.
These forces include political turmoil, currency fluctuations, weather, employment,
business sentiment surveys, and a host of other variables that factor into what investors
think about the current and future investment environment. But perhaps the most
powerful force impacting stock prices, apart from earnings, is interest rates, and the
expectation of inflation or deflation.
The overall level of interest rates, and the expectation of future changes in interest rates
are important to stock prices. Because all investment vehicles (stocks, cash, bonds, real
estate, etc.) are in competition against one another within an investor’s asset allocation,
interest rates set a benchmark for the required level of return that investors demand on
their capital. In order to keep up with inflation, interest rates generally must be greater
14. 14
than the rate of inflation. Otherwise a decline in real wealth is suffered. People buy
stocks because they expect the return on investment will compensate them for the risks
taken. The Capital Asset Pricing Model (CAPM) is a tool used by professions to value
stocks. The CAPM states that the required return on investment includes the “risk free
interest rate” plus a risk premium. The risk free interest rate is essentially the U.S.
government ten-year bond yield. When interest rates are rising, the required rate of
return on stocks is driven higher. The higher required rate of return puts downward
pressure on stock prices because essentially represent the future earnings and cash flows
that the company will produce. These cash flows are discounted to present value at the
required rate of return based on the CAPM. When interest rates rise, the required rate of
return rises and the present value (which is the stock price) goes down. When interest
rates fall, stock prices receive a tail wind.
The risk premium is the additional return (or additional interest rate) that investors
demand for investing in stocks as a group or individually. On average, the historical risk
premium for the entire stock market has been about three percent, but it can vary greatly
for individual stocks depending upon factors such as earnings volatility, trading liquidity,
and other variables. Another factor that impacts the risk premium is simply investors’
willingness to accept risk. If investors as a group are fearful or cautious, the risk
premium will be higher, making stocks more attractively valued (“cheaper”). But when
investors largely ignore the risks and become greedy, the risk premium declines and
price/earnings ratios increase. In the very short-term it is extremely difficult to measure
the risk premium due to all the factors involved. However, because stocks tend to trade
within a band around the price/earnings ratio (typically 14 to 18 times earnings for the
S&P 500 in a normal interest rate environment), it’s not too difficult to get a feel as to
whether stock valuations are overly depressed or excessive.
Two distinct periods help demonstrate the impact that interest rates have on the stock
market. The first is from 1954 to 1981. During that period the ten-year treasury bond
yield rose from 2.5 to 13.7 percent, and the rate of inflation grew from 0.3 to 10.4
percent. Earnings on the S&P 500 during that period grew from $2.77 to $15.36,
compounding at just over 6.5 percent. The price of the S&P 500 rose from $35.98 to
$122.55, but that only represents a 4.6% rate of compounding, almost two full percentage
points less than the earnings growth rate. The difference is due to the headwind created
by rising interest rates and rising inflation, which took the price/earnings ratio for the
S&P 500 from 13.0 times in 1954 to 8.0 times in 1981. It is not by coincidence that the
decline in the price/earnings ratio represents an annual negative return of just below 2%.
The period from 1981 through 2006 illustrates the impact from declining interest rates.
Treasure bond yields fell from 13.7 to 4.6 percent and inflation fell from 10.4 to 3.2
percent. S&P 500 earnings grew from $15.36 to $88.26 and its price increased from
$122.55 to $1,418.55. During that period the S&P 500’s price compounded at 10.3
percent, 3 percent faster than the earnings growth rate. The decline in interest rates and
inflation made the difference, resulting in an expansion of the S&P 500’s value from 8
times earnings in 1981 to 16 times at the close of 2006. The combination of rising
15. 15
earnings and falling interest rates is clearly the best possible investment environment for
stocks.
During both of the above periods, earnings growth was the predominant factor in driving
stock prices higher, but it is clear that major changes interest rates and inflation can have
substantial impacts on stock valuations.
That covers inflation, but what about deflation? Deflation is bad. It stifles both
consumption and investment. A deflationary environment is one where the prices of
goods and services are generally declining. In a deflationary environment, people reduce
their consumption because they know their money will be worth more in the future just
by sitting on it. Deflation is the only environment where “stuffing money under the
mattress” is a sound policy. During deflation, people hold on to their money like it was
money! Why buy today what you can buy tomorrow cheaper? Business investment also
declines for the same reason. Businesses invest in capital equipment in order to earn a
return on that investment. But if the future dollars that investment earns are worth less
than today’s, businesses will hold their capital rather than invest it. That stifles growth.
If you don’t believe deflation is bad, just look at the Japanese stock market. It declined 90
percent from its peak when deflation took hold. Not convinced? The Great Depression
during the 1920s also experienced a deflationary spiral, which coincided with the U.S.
stock market declining 85 percent from its peak.
As far as growth is concerned, the faster the better. No matter what the interest rate
environment, faster growing companies have generally provided the greatest returns to
shareholders. But fast growth by itself is not enough. Growth must also be sustainable
over several years. The big money has been made in companies that are on a growth
track and stay on that track for long periods of time. As previously explained, it’s easier
for companies to sustain rapid growth in their infant and adolescent stages than in their
mature adult phase. To illustrate the power of earnings growth, Table 1 compares
earnings-per-share growth rates against stock price appreciation for various large U.S.
corporations. Large companies were selected because they had long enough operating
histories to make meaningful comparisons. Additionally Large-cap stocks have better
coverage by professional analysts, which makes it more difficult for investors to exploit
information that is not already in the stock’s price. The top half of the table shows
companies with above average growth rates. The lower table includes below average
growth-rate companies. Table 1 clearly shows that faster growing companies reward
investors more handsomely.
It is also evident that the company’s business or industry doesn’t really matter. A fast
growing financial services company will perform just as well as a fast growing
technology company, and a slow growing technology company will perform just as
poorly as a slow growing chemical company. If you are interested in seeing a stock’s
price move higher, you should care more about the earnings growth rate and its
sustainability, and care less about what industry the company participates in. However,
you should care that the industry opportunity is large and provides ample room for
growth. After all, a healthy swamp provides for healthy alligators.
16. 16
Table 1. Earnings and Stock Price Comparisons
Earnings Per Share Growth vs. Stock Price Appreciation 1986 to 2006
% Change Annual Stock
Company Name Industry EPS Price Return
Proctor & Gamble Consumer Products 12% 14%
Merrill Lynch Financial Services 23% 20%
Johnson & Johnson Healthcare 14% 15%
Wal-Mart Retail 17% 15%
Caterpillar Inc. Industrial Equipment 14% 12%
Microsoft Technology 28% 26%
Kellogg Co. Consumer Products 6% 7%
DuPont Chemicals 5% 7%
IBM Technology 6% 7%
AT&T Telecommunications 5% 8%
General Motors Automobiles -2% 1%
Eastman Kodak Consumer Products -9% -2%
Figures 2 through 13 are graphic illustrations comparing earnings-per-share and price for
each of the above companies. These charts are identical in nature to the Figure 1, except
they are for individual stocks rather than the broad stock market; and the time period is
shorter. But the relationship still holds. Earnings-per-share and stock prices are linked.
There is no getting away from it.
Figures 2 – 13. Individual Stock Price and Earnings Comparisons Over Time
Proctor & Gamble Price vs. EPS
$0
$10
$20
$30
$40
$50
$60
$70
$80
19861987198819891990199119921993199419951996199719981999200020012002200320042005
$0.00
$0.50
$1.00
$1.50
$2.00
$2.50
$3.00
$3.50
Price
EPS
20. 20
General Motors Price vs. EPS
$0
$10
$20
$30
$40
$50
$60
$70
$80
19861987198819891990199119921993199419951996199719981999200020012002200320042005
($10.00)
($5.00)
$0.00
$5.00
$10.00
$15.00
Price
EPS
Eastman Kodak Price vs. EPS
$0
$10
$20
$30
$40
$50
$60
$70
$80
$90
19861987198819891990199119921993199419951996199719981999200020012002200320042005
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
Price
EPS
There are a couple more observations between the overall stock market and the individual
stocks. During the late 1990s, the stock market experienced a bubble when a frenzy of
buying in growth stocks drove valuations to historically high levels. But by looking at
the individual stocks charts, you see that not all stocks were treated equally. The low-
growth companies did not experience the same frenzy and were largely ignored, while the
high-growth stocks received a disproportionate share of the buying interest and rocketed
to unsustainable levels. It further illustrates the power of growth on stock prices. The
bubble ultimately burst, and rightly so. The excessive valuations were brought back to
normal levels. Investors who were smart enough (most people weren’t) to sell at the top
made a killing. But even if they didn’t sell at the top, and just held those stocks through
the entire period, investors still did better than if they had invested in low-growth
companies.
The second observation is that can be seen more clearly is the impact on a stock’s price
when earnings decline. A broad market index like the S&P 500 includes many
companies in many industries. Except during recessions, companies and industries that
21. 21
are suffering declines are generally more than offset by those that are experiencing
growth. That is the main benefit of diversification with an index. You don’t have to
worry about which companies are going to lead the charge. You will own the winners
and the losers, but overtime, the winners will more than offset the impact from the losers.
But when buy individual stocks as opposed to investing in mutual funds or index funds, it
is important that to spend the time identifying the current and emerging leaders. Buying
a second rate company in an industry just because it is cheaper than the leader is a loser’s
strategy!
If you don’t have the time or inclination to properly research individual stocks, then stick
with mutual funds. If you don’t have the time or inclination to properly research actively
managed mutual funds, stick to index funds.
Some investors like to look at growth in a company’s book value or growth in dividends
when they invest. By doing this, they are missing one huge point. A company can’t
grow its book value long-term without generating earnings, and if the company’s
earnings aren’t growing, it means the company has most likely become mature or
stagnant, and its best days have most likely past. The same argument can be made for
dividends. Dividends are paid out of the earnings and cash flows that a company
generates. If earnings won’t grow, neither will the dividends. Not only that, but
companies that are in rapid growth modes are generally reinvesting their cash back into
the business and not yet paying dividends. If your objective for investing in stocks is to
achieve capital gains and build real wealth, then stick with earnings growth as your
primary focus.
It should be clear now that why earnings growth is the primary determinant to stock
prices, and how changes in interest rates can have a secondary effect. As of today (late
2008), interest rates are at the lower end of their historical ranges, and inflation pressures
may also be increasing given the amount of money that governments are putting into the
global economies. Given that, investors in the U.S. stock market today should not expect
the kind of returns seen over the past twenty-five years because there is not likely to be a
tailwind from declining interest rates. This means that from today, earnings growth will
be as important as ever.
22. 22
CHAPTER 3: THE JOYS OF ADOLESCENCE
Chapter 1 described the way of the alligator. Infant and adolescent alligators are fast
growing, and adults grow slowly. Infant alligators are high risk, and adolescents and
adults are lower risk. Chapter 2, laid out that long-term stock price appreciation is
primarily driven by growth in earnings-per-share. There should be no surprise at this
point where this is leading. Midcap stocks, the adolescents of the stock market, represent
the best opportunity for long-term capital appreciation and wealth creation without taking
on an excessive amount of risk.
Figure 14. Compounding of a Dollar Over Time
Growth of a Dollar 30 Years Ended 2007
$-
$10.00
$20.00
$30.00
$40.00
$50.00
$60.00
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
Large Cap
Mid Cap
Small Cap
Figure 14 shows the growth of a dollar invested for the past 30 years in small, mid, and
large-cap stocks. When investors move down in market capitalization, they are taking on
additional risk. To compensate for the additional risk, they expect to earn higher returns.
In general, that has been the case. Investors in small and midcap stocks did achieve
higher returns relative to large-cap stocks. A dollar invested in large-cap stocks 30 years
ago would be worth about $34 dollars at the end of 2007, while a dollar invested in small
and midcap stocks would be worth $51 and $60, respectively.
However, it appears that by moving too far down in size, additional compensation is no
longer being rewarded for the additional risk. After all, midcap stocks generated higher
returns than small-cap stocks. The primary reason for this is the survivorship risk in the
small-cap area of the market. Remember that fourteen percent of the companies in the
Russell 2000 small-cap index are unprofitable versus only four percent in the Russell
Midcap index. So although an individual small-cap company may be fast growing, as a
group they don’t grow any faster because the survivors have to more than offset the
declines generated by the unprofitable and unhealthy infants who are also included in the
small-cap index. Midcap companies fight a lesser headwind in that regard.
23. 23
Another reason that midcaps have beaten small-caps is that there are a limited number of
large industry opportunities to exploit. As a result, many small companies are limited in
their ultimate size because the industry in which they operate is also small. A company
may be the dominant shirt button manufacturer, but the shirt button industry will always
be a small swamp incapable of supporting a real giant.
Finally, the small-cap area of the market has in recent years become a source of public
venture capital. Typically, the riskiest companies seek start-up capital from the private
capital industry. In the private capital stage, they further develop their business models
and work to achieve enough support to become profitable and self-sustaining. After
achieving this, the company lists itself on the public market by filing an Initial Public
Offering, the main purpose of which is to raise funds to pay back the private investors
and to raise additional growth capital for the company. However, as investors’ risk
appetite has increased over time, more companies are leaving the nest before being fully
incubated. Riskier companies are going public earlier. For evidence of this, look no
further than at all the unprofitable technology companies that went public in late 1990’s.
When unprofitable companies go public, they join the ranks of the unhealthy 14 percent
of the small-cap index. Many of these companies will ultimately expire.
Figure 15.
Growth of a Dollar 25 Years Ended 2007
$-
$5.00
$10.00
$15.00
$20.00
$25.00
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Large $18.80
Mid $24.50
Small $15.00
To see the picture more clearly, take a peek at figure 15, which shows the growth of a
dollar over the past twenty-five years invested in small, mid, and large-cap stocks. You
can see that midcap stocks again were the winners. But what also jumps out is not only
did small-cap stocks return less than midcaps, but they also returned less than large-cap
stocks! Most individual investors today do not understand the degree of risk they are
taking in the small-cap arena. Many are told by financial advisors that in order to
enhance long-term returns and to distribute risk, they need to diversify their assets across
24. 24
all categories, including small-cap. Investors certainly need to diversify, but not blindly.
Adding small-cap stocks (especially small-cap growth stocks) to the mix of assets not
only reduced long-term returns, but increased risk. That is a poor trade off. Adding
midcap stocks to the investment portfolio however served to both raise returns and lower
risk.
Table 2 displays the annualized rates of return and standard deviations for small, mid, and
large-cap stocks for both the past twenty-five and thirty years. The standard deviation is
a measure of risk, and in this case measures the volatility of past returns. Stocks with
annual returns that experience large swings from year to year will have a larger standard
deviation and are considered more risky. The data show that midcaps have not only
provided larger returns than large and small-caps, but that midcap returns have actually
been less volatile than both large and small caps.
Given that midcaps at face value should be more risky than large-caps, it seems unusual
that midcaps would have a lower standard deviation. This lower risk is a statistical
aberration caused by the bursting of the 1999 stock market bubble. Prior to 1999,
midcaps did experience a higher standard deviation accompanied with higher returns.
But the bull market of the late 1990s was focused primarily on large-cap stocks and
technology. During the five-year period ended 1999 large-caps had annual returns higher
than midcaps in each year, outpacing midcaps by over six percent annually. When the
bubble burst, it hit large-caps harder than midcaps since the midcaps did not experience
the same kind of extreme valuations that were created in the large-cap area of the market.
During the subsequent five years ended December 31, 2004 large-caps lagged midcaps in
each year, and by over nine percent annualized. That ten-year period of higher volatility
for large-caps was uncharacteristic of how stocks normally act across a cycle. Typically
in bear markets, smaller capitalization stocks decline more than large caps due to a “flight
to safety” by investors as they attempt to reduce risk. They sell the small-caps due to
their inherently higher risk, and seek refuge in the security of large-caps who provide
more resilient businesses. The lower trading liquidity of smaller caps makes selling more
difficult in a bear market resulting in more pronounced price declines.
Table 2. Long-Term Index Comparisons
Annualized Average Returns Large Cap Mid Cap Small Cap
30 years ending 2007 12.8% 14.5% 13.4%
Std Dev 30 yrs ending 2007 15.3 14.9 17.8
25 years ending 2007 12.5% 13.6% 11.4%
Std Dev 25 yrs ending 2007 15.8 15.3 17.6
But even in more “normal” markets, midcaps will generally provide better risk-adjusted
returns versus both large-cap and small-cap stocks. It appears that midcaps and
adolescence is the stage where the process of creative destruction gains momentum.
Much has been written about the process of creative destruction in the field of economics.
Creative destruction is the process whereby existing established industries become
25. 25
obsolete and replaced by newer emerging technologies. Younger entrepreneurial
companies typically own the newer technologies. These companies in turn achieve their
greatest shareholder returns in the midcap stage as their products and services enter the
mass adoption phase by consumers. Monster Worldwide, a leader in online recruitment
advertising, has changed the way prospective job seekers and employers connect.
Recruitment advertising was once the domain of the daily newspaper and is now rapidly
moving to the Internet. Apple’s iPod has led the charge in changing the way people buy
and listen to music. Apple has virtually eliminated the Sony Walkman as well as several
music retailing stores. History provides several examples of creative destruction, which
ultimately improves standards of living by eliminating established inefficient processes,
thereby freeing up resources to be redeployed into more productive efforts.
Illustrated above is that midcap stocks have provided the best path to enhancing long-
term returns without accepting an unreasonable level of risk. But how do midcaps
measure up against large and small-caps over shorter time horizons? Table 3 details the
rolling five and ten-year annual returns for all three categories for the past twenty-five
years. Midcaps have beaten large-caps in seventeen of the past twenty-five rolling five-
year periods, 68 percent of the time. Over ten-year rolling return periods, midcaps beat
large-caps 70 percent of the time. During the times that midcaps lagged large-caps over
ten years, the average shortfall was only three-quarters of one percent, with the worst
shortfall being 2.3 percent. This shortfall occurred during the large-cap stock market
bubble in the late nineties and was a period where midcaps still returned almost seventeen
percent during that ten-year period. However, the average beat by midcaps during the
rolling ten-year periods was two and three-quarters percent, 3.7 times greater than the
percentage shortfall. For the past three, five, ten, twenty-five and thirty years, midcaps
have been the best place to invest in U.S. equities.
Is there a case for small-caps? Not really. Small-caps beat large-caps less than 50
percent of the time in both rolling five and rolling ten-year periods. But in many of the
periods that small-caps posted higher returns than large-caps, small-caps were beaten by
midcaps anyway. There has not been a strong argument for investing in small-caps for
the past twenty years. The main drag on small-caps has ironically been due to “growth”
stocks. Small-cap value has actually been a good place to invest, but midcaps have done
just as well in the value category (adolescence still rules). This will be explained in more
detail in Chapter 8. In summary the data show that an investor’s portfolio should include
both large and midcap stocks. The longer the investor’s time horizon, the larger the
allocation should be to midcaps in order to take advantage of their higher appreciation
potential.
26. 26
Table 3. Rolling Five and Ten Year Return Comparisons by Market Cap
Rolling Annualized 5 Year Returns
Rolling Annualized 10 Year
Returns
Large Cap Mid Cap Small Cap Large Cap Mid Cap Small Cap
1982 14.3% 19.2% 24.0% 6.2% 11.9% 15.7%
1983 17.6% 22.2% 26.7% 10.0% 17.6% 23.3%
1984 14.0% 16.0% 16.1% 14.1% 21.2% 25.8%
1985 14.1% 15.9% 14.8% 14.0% 18.9% 23.2%
1986 19.1% 19.3% 15.7% 13.6% 17.0% 19.0%
1987 15.5% 14.4% 12.5% 14.9% 16.8% 18.1%
1988 14.6% 13.7% 11.8% 16.1% 17.9% 19.0%
1989 19.7% 18.9% 17.0% 16.8% 17.4% 16.6%
1990 12.2% 9.7% 6.1% 13.1% 12.8% 10.4%
1991 14.9% 13.8% 13.2% 17.0% 16.5% 14.4%
1992 16.2% 17.2% 15.1% 15.9% 15.8% 13.8%
1993 14.8% 16.1% 14.0% 14.7% 14.9% 12.9%
1994 9.0% 10.3% 10.2% 14.2% 14.5% 13.5%
1995 17.2% 19.9% 21.0% 14.7% 14.7% 13.3%
1996 15.3% 15.8% 15.7% 15.1% 14.8% 14.4%
1997 19.9% 18.2% 16.4% 18.1% 17.7% 15.8%
1998 23.4% 17.3% 11.9% 19.0% 16.7% 12.9%
1999 28.0% 21.9% 16.7% 18.1% 15.9% 13.4%
2000 18.2% 16.7% 10.3% 17.7% 18.3% 15.5%
2001 10.5% 11.4% 7.6% 12.8% 13.6% 11.5%
2002 -0.6% 2.2% -1.3% 9.2% 9.9% 7.2%
2003 -0.2% 7.2% 7.1% 11.0% 12.2% 9.5%
2004 -1.8% 7.6% 6.6% 12.1% 14.5% 11.6%
2005 1.1% 8.5% 8.2% 9.3% 12.5% 9.3%
2006 6.8% 12.9% 11.4% 8.6% 12.1% 9.5%
2007 12.4% 16.9% 15.4% 5.7% 9.3% 6.7%
The Adolescent Investor
For the moment, let’s spend a little time on adolescent humans, not alligators. Young
investors have one huge advantage over the middle-aged in saving for their retirements.
That advantage is time. By investing early in life, the power of compounding can work
to its fullest benefit. If you are a teenager or young adult reading this book,
congratulations! You are already thinking about your future financial security and have
plenty of time to build a financial fortress. If you are older, you should still be proud of
yourself for focusing on your future. Hopefully you started the saving process earlier, but
it is never too late to start. It is also never too late to teach your children or grandchildren
about saving and its importance to long-term financial health.
The power of compounding can indeed be formidable. To demonstrate its effect, let’s
assume Joe is 22 years of age and just graduated college. He just starting in his new
career and although he knows he needs to save for the future, he can’t save a lot because
he needs to pay for rent, food, transportation, dating and other essentials. But Joe needs
to save some, so he puts away $200 a month, either in an IRA or in his employer-
27. 27
sponsored 401k plan. As his career progresses he starts to earn more and can save more.
He saves $300 a month in his thirties and then $400 in his forties and $500 a month after
turning 50 until age 60. Let’s also assume Joe invested it all in a large-cap index fund
since that is a smart choice to avoid high fees which eat into investment returns; and that
Joe’s investments on average earned 9 percent per year (the average rate of return for the
stock market over the last century was 10%). Based on the above, by age 65 Joe’s
retirement account would be worth over 1.5 million dollars. His total contributions (cash
out of pocket) into the account from age 22 through 60 were only $165,600. By saving
early, Joe made over nine times his original investment. That’s the power of
compounding.
But saving is boring. Why not take that extra cash and get a slightly nicer car, or some
extra clothes? Carpe Diem after all! Fair enough. Nobody likes a killjoy. So Joe starts
saving at age 30, instead of 22, and everything else stays the same. It shouldn’t make that
big of a difference since he only contributed $21,600 during his twenties, right? Wrong!
By waiting until he turned thirty, Joe’s savings at age 65 shrink to about $950,000. That
delay of $21,600 cost him over a half million dollars at age 65! In order to make up for
skipping saving in his twenties, Joe now needs to save $600 per month starting at age
thirty through age 60. An extra $50,000 in total contributions is required. If he waits
until he is 40, Joe’s monthly savings requirement jumps to $1,600. That’s $218,000 more
in contributions that needs to be paid out of pocket! Delaying retirement savings places a
disproportionately higher burden on future contribution requirements. That is why it is
important to start a retirement savings program early and to stick with it. Life is full of
choices. In the case of retirement savings, the choice is between starting now versus
working harder and longer later.
Because every individual’s saving and retirement requirements are unique, it is
worthwhile to spend a little time on your own plan. This will help determine if you are
on track and what kind of retirement savings you can reasonably expect to have in the
future. If you are proficient at using spreadsheet software, it will be easy to create a
worksheet to run various simulations for retirement planning. But if you are not a
spreadsheet wizard, there a lot of good tools available on the Internet to help understand
the retirement savings requirement. These may be found on your employer’s retirement
plan site or at your on-line broker/mutual fund family’s website. A simple tool to use is
the retirement plan calculator on Yahoo Finance. Just visit http://finance.yahoo.com and
click on the “Personal Investing” tab. Yahoo Finance multiple calculator tools to assist
individuals in planning their retirement.
Parents can do two major things for their children to make their futures more promising.
The first is to encourage them to obtain advanced learning and acquire skills needed for
higher paying jobs. That doesn’t necessarily mean a college degree, although that surely
helps. There are some fairly poor accounting majors and fairly wealthy plumbers. Both
professions require specific learning. The learning may come from a trade school rather
than be provided by an Ivy League college. The main point is to acquire skills that are
demanded in the market place. The second major thing parents can do is to open a
savings account for their child (or children) and to invest money into the stock market for
28. 28
them. There may be no better way to teach someone, especially a child, than through
example. At age five, start putting away $50 per month for the child until she (or he) is
18. Talk to her about saving and its importance to her future. At nine percent, her
savings account will be worth over $15,600 at age 18. She will be witnessing first-hand
the power of compounding. Explain to her that even if she never adds another nickel to
the account, at age 65 the power of compounding will turn that $15,600 into almost
$900,000. This assumes an average return of nine percent with no taxes, but if you invest
in an index fund, a great deal of the return will indeed be tax-free. For a total cost of
$8,400, you can teach your children an invaluable life lesson, and perhaps send them on
their way to becoming a future millionaire.
All of the above examples were based on a 9 percent rate of return, a little less than the
average return of the U.S. large-cap stock market over the last century. This rate was
used to be conservative and to demonstrate that astronomical rates of return are not
required in order to build long-term wealth. But if history is a guide, rates of return can
be increased by adding some tasty adolescent alligators into the mix. Assuming a 50/50
blend of large-caps and midcaps increases the rate of return to 9 ¾ percent. That is
reasonable given historic results. Using the above example of Joe’s savings program
starting at age 22, the additional ¾ percent increased the expected value at age 65 by
$360,000 to almost $1.9 million. In the extreme case of investing Joe’s assets entirely in
midcap stocks (an imprudent investment decision which is not recommend), and
assuming a 10.5 percent rate of return (not unrealistic), the value at age 65 jumps to over
$2.3 million.
Adding the power of adolescence and midcaps to an investment program greatly
enhances the ability to achieve long-term wealth objectives without taking unwarranted
risk. Table 2 above shows the 30-year rates of returns and standard deviations separately
for large-cap and midcap stocks. By combining these results using a 50/50 mix between
large and midcaps and rebalancing annually, an annualized return 13.7 percent is
realized; but the combined standard deviation actually drops to 14.5. Adding midcaps to
the asset mix not only increased the annual rate of return above that of large-caps, it
actually lowered the risk of the overall portfolio by increasing the stability of returns.
This is how diversification is supposed to work. Clearly any good long-term investment
program should include midcap stocks in the allocation.
29. 29
CHAPTER 4: ALLIGATOR ANATOMY
Each individual alligator is unique with its own individual characteristics, including
color, size, distinguishing scars, or other attributes. However at the core, all alligators are
the same. They are flesh and blood. They all have powerful jaws, four legs, a tail, and a
thick hide. Their biology is the same, each having a stomach, lungs, heart, liver etc.
They all spend their lives doing essentially the same thing … feeding, fighting and
breeding as they struggle to survive.
It is the same situation for companies. Each individual company is unique, with its own
set of products and services, facilities, and other attributes. Colgate sells toothpaste and
household products. Disney manages theme parks and produces other entertainment
services. Wells Fargo provides loans and other financial services. Starbucks sells coffee.
Exxon extracts oil and sells gasoline, diesel fuel and other refined products. Each
business is unique with its own set of challenges in its struggle to survive. However at
the core, all companies are the same. When you break it down, all companies do
essentially the same thing … money comes in and money goes out. They are all money
machines, and the companies that provide the greatest returns to shareholders will be the
ones that make the most money in the form of earnings-per-share.
Money comes into a company primarily from revenue generating activities, mainly by
selling products or services to its customers. Sure a company can raise money by issuing
debt (borrowing) or stock (selling an ownership interest in itself), but if a company is to
grow and be self-sustaining, it needs to generate revenues in excess of its internal
survival needs. A company that isn’t selling enough to pay its bills is dependent on
external sources of funds to survive. It is not in as much control of its destiny as a
company that generates free cash flow. If the banks become unwilling to lend, or if the
company cannot sell a piece of itself to an outside investor, it will perish.
Money goes out of a company to support the expense structure. This includes the cost of
goods sold, selling expenses, general and administrative costs, research and development
expenses, taxes and other costs. A company has to spend money on materials, inventory,
employees, buildings, equipment, insurance, accountants, lawyers, and the other
necessary expenditures to support its business. All businesses have this in common. If
money is left over after paying the necessary expenses, the company can reinvest the
extra money in growth initiatives to create new products, expand into new territories, or
make strategic acquisitions. The company may choose to return the excess cash to
shareholders in the form of dividends or corporate share repurchases. Corporate share
repurchases increase shareholder value because by repurchasing shares, earnings-per-
share is increased by spreading earnings across a reduced number of shares. For
example, if a company generates ninety dollars in earnings and has ten shares
outstanding, earnings-per-share is nine dollars. If the company buys back one of those
shares, earnings-per-share increases to ten dollars (ninety divided by nine). While
earnings remained flat, earnings-per-share increased due to a corporate share repurchase.
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This may seem elementary, but it should be obvious that all companies sell products and
services, and they all have to pay their expenses. The point is that no one should really
care how a company makes its money. One man’s trash is another man’s treasure.
Money is money. Earnings-per-share is earnings-per-share. Try to avoid value
judgments about a company’s business until after looking under the hood to determine
what kind of excess cash flow it throws off. Ross Stores is a retailer that focuses on
selling to customers with an average household income of $45,000. Ross Stores
specializes in buying apparel manufactures’ discards in the form of past season’s fashion
and other closeout or excess merchandise, and then selling it to consumers at a discount.
Their tag line is “dress for less.” Ross is not at the leading edge of fashion or a luxury
retailer by any stretch of the imagination, but it satisfies a basic need (clothing) with a
good product at an affordable price. Tiffany is at the other end of the spectrum. It sells
diamonds, jewelry, and is famous for its “blue box.” Not only does their inventory not go
out of fashion or spoil, it increases in value while just sitting on the shelves. It is not
uncommon for a Tiffany customer to spend on one purchase more than what the average
Ross Store’s customer makes in a year. Tiffany’s quality is impeccable, and its stores are
located in the most prestigious markets. Tiffany must be a better business than Ross
Stores. However, the stock price and the business fundamentals tell a different story.
Figured 16. Ross Stores Versus Tiffany & Co.
Ross Stores Vs. Tiffany & Co.
Stock Price Appreciation
$0
$10
$20
$30
$40
$50
$60
198719881989199019911992199319941995199619971998199920002001200220032004200520062007
$0.00
$10.00
$20.00
$30.00
$40.00
$50.00
$60.00
Ross
Tiffany
Over the years, Ross Stores has substantially rewarded its shareholders. Ross’s stock
price compounded at a 21 percent rate in the twenty years ended 2007, while Tiffany
returned 18 percent. During that period, Ross Stores grew its earnings at a 20 percent
rate versus 12 percent for Tiffany. Although Ross sells past fashion and closeout
merchandise, it does it very effectively. Its gross and operating margins are below
Tiffany’s, but Ross makes up for this in velocity, turning its inventories four times faster
than Tiffany. This results in a return-on-equity that is almost fifty percent higher than
Tiffany’s with Ross actually carrying less debt. By not tying up cash in inventory, Ross
Stores generates significant free cash flow, which it uses to expand its store base, pay
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dividends and repurchase shares. In recent years, Ross Stores has stumbled a bit. The
implementation of a new information system did not go smoothly and caused some
business disruption that lowered their operating margins. If Ross Store’s management
works through these issues, operating margins should expand and Ross should re-emerge
as a leader in retailing.
In just a few simple steps, the financial health of any company of interest can be checked
fairly quickly. The Internet has made accessing financial information on companies
extremely quick and easy. Summary financial information can be found on Yahoo
Finance. Just enter the ticker symbol for the stock of the company being researched, and
in the tabs of the internet pate will be listed options for balance sheet, income statement,
and cash flow statement summary information for the past three years. For more detailed
information, go directly to the company’s website and click through to their investor
relations section. Almost every company will have available their most recent annual
reports and a tab to click directly to their required public SEC (securities and exchange
commission) filings. The filings you should be most concerned with are the annual 10K
filings, quarterly 10Q filings, and proxy statements (Schedule 14A).
Most companies these days are doing a good job of providing information on their
websites that use to be available mainly to professional investors. These include webcast
replays of presentations that companies have given at investor conferences, and replays
of their quarterly earnings conference calls. If these are available, they can be valuable in
gaining additional insights into the company’s growth strategy, current opportunities they
are exploiting and potential challenges they are facing. Not only can individual investors
get an outlook update directly from the company’s management, they can hear Wall
Street analysts’ questions and concerns along with the company’s response to those
issues. For those who have the time to spend reviewing these calls, it’s well worth the
time. If those who don’t, they probably shouldn’t be investing directly in stocks and
should stick with funds and indexes.
At a minimum, the serious investor should read the annual report. Companies (should)
put a lot of time and thought into preparing their annual report and Form 10K. This is not
only their progress report to shareholders, but also one of their main shareholder
marketing pieces. The annual report is where a company can lay out its long-term
strategy, execution plan and business opportunity. Make sure to read the Chairman’s
letter and other information summarizing the company’s business segments. The annual
report many times gives a sense of the company’s culture and focus, which are critical to
its success. Form 10K (the required annual SEC filing) includes a lot of information.
Not only does it include the financial statements, but also the business description
including a list of potential risks. It details key management personnel along with their
backgrounds. If not included in the 10K, this information may be included in the
company’s annual proxy statement. The proxy also shows the level of management
ownership in the company and its executive compensation schedules.
Here are the eight simple checks to perform on any company that is a potential
investment.
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Step 1. Is the company profitable? This information can be found by looking at the
company’s income statement, either in the annual report or Form 10K. Look at the net
income line. The company should demonstrate that it is consistently generating a
positive net income from operations. Alligator investors are not interested in unprofitable
or any other kind of unhealthy business.
Step 2. Is the company really profitable, or is it just accounting gimmickry? Too many
investors just look only at a company’s income statement to evaluate its profitability.
That is a huge mistake. Companies can generate paper profits for short periods of time (a
few years even) by manipulating accounting rules. If profits aren’t supported by real
cash flow, there is a good chance that the company is a house of cards waiting to
implode. This was the problem with Enron Corporation, HealthSouth Corporation,
Krispy Kreme Donuts, and many other high-profile corporate frauds. To validate the
quality of income statement earnings, turn to the cash flow statement. The cash flow
statement separates a company’s cash flows into operating activities, investing activities
and financing activities. Take total cash flows from operations and subtract capital
expenditures. Capital expenditures can be found in the investing activities section of the
cash flow segment. Operating cash flow less capital expenditures is called “free cash
flow.” If cash flows from operations minus capital expenditures are consistently positive,
then the company is healthy and income statement earnings are more reliable and
potentially sustainable. Operating cash flows don’t have to exceed capital expenditures
in each individual year, but over time the company should be generating more operating
cash flow than its capital expenditure requirements. It should be generating free cash
flow.
If a company is consistently spending more on capital expenditures than it is generating
from internal operations, that means it is reliant on external sources of cash to fund its
growth. It must either borrow or sell additional shares, which dilutes the existing
shareholders’ interests. It means the company is not self-sustaining and most likely
should be avoided. In some hyper-growth situations, capital expenditures may exceed
operating cash flow because the company wants to take advantage of its growth
opportunity before too many competitors come in and spoil the market. This was the
case with Starbucks and other retail/restaurant concepts in their earlier stages, and is the
case today in many of the solar industry companies. Ultimately Starbucks and the other
successful business plans achieved consistent free cash flow. However, the landscape is
littered with companies that were long on promise and short on results. When investing
in high growth companies that are not yet generating free cash flow, it is important to
have a good grip on the company’s long-term plan and its ultimate path to real economic
profits. If that level of confidence cannot be obtained, it may be prudent to wait for the
company to prove itself by generating free cash flow, and then invest at that point.
Step 3. Is profitability improving? Companies that are experiencing improving
profitability benefit not only from rising sales but also from higher profitability on those
sales. The combination of rising sales combined with improving profitability is a
powerful driver to earnings growth and generally results in attracting money into a stock.
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Stocks with improving sales and profitability tend to experience higher returns than the
market in general. Key figures to look at in evaluating profitability are the operating
margin and the return-on-capital. The operating margin can be calculated from the
income statement, and represents operating income (earnings before interest and taxes)
divided by net revenues. Operating margin represents the percentage of each revenue
dollar that accrues back to the company. If operating margin improves from seven to
nine percent, that means that for every $100 in revenue, the company keeps an extra two
dollars before taxes. Return-on-capital measures how profitable the company is for each
dollar of capital invested in the business. It is a measure of how efficiently the company
deploys capital. Capital includes both equity and long-term debt (including the current
portion of long-term debt). To calculate the return on capital, divide net operating profit
after tax by the average capital for the year. A quick and dirty way to get to net operating
profit after tax is to take operating profit from the income statement and multiply it by
one minus the company’s income tax rate. To calculate average capital, add equity and
long-term debt at the beginning and end of the year and then divide by two. If the
company has no debt, you can simply use return on equity as a close enough
approximation for return-on-capital. Even if the company does have debt, if the amount
of leverage (the debt-to-equity ratio) employed in the business is fairly constant, you can
still use the change in return-on-equity as a rough guide to tell if profitability (in the form
of capital efficiency) is improving or deteriorating.
It is preferable to own stocks that are experiencing rising operating margins and
improving returns-on-capital (or returns-on-equity). These are indications that business
is strong and the company is improving its position in the industry. A company can still
grow earnings while experiencing declining operating margins and returns-on-capital if
its revenue growth is fast enough to offset the decline in profitability. However, this is an
indication that the additional business the company is going after is not as good as its
existing business base, and that growth will be slowing and may perhaps flatten out or
decline. Generally, stocks that are experiencing declining profitability have a harder time
beating the broader stock market and should only be purchased at steep discounts to their
fair value.
Step 4. Is the company financially solid? Again, investors should avoid sick alligators.
A financially solid company has a strong business model that can weather recessions and
other setbacks when they occur. One aspect of being financially solid is the generation of
free cash flow discussed above in step 2. The other aspect is the amount of financial
leverage in the company. In other words, how burdensome is the company’s debt load.
Companies use debt in their capital structures for various reasons. When purchasing
long-term assets like equipment or buildings, a company will finance a portion of the
purchase with debt, much the same way an individual borrows to purchase a home or a
car. The cash flow the company expects to generate from the use of the equipment and
building will go towards paying off the debt in the future. Debt financing may be
required for a strategic acquisition. A company may take on debt to repurchase shares
and lower its overall cost of capital. The cost of debt is the interest payments on the debt.
The interest cost of debt is typically less than the company’s cost of equity. If a company
has steady cash flow, it makes sense to hold some debt and reduce the number of shares
34. 34
outstanding which results in a greater earnings-per-share for the remaining shareholders.
Additionally, interest is tax deductible, making the cost of debt lower still. To check a
company’s debt level, look at its balance sheet. Add long-term debt and the current
portion of long-term debt. Divide this by total shareholders’ equity. The lower the
number the better. A debt-to-equity ratio of 1 or less is preferable. Anything above one
is highly leveraged and should generally be avoided.
Step 5. Are earnings per share growing? Alligator investors want companies that are
growing earnings-per-share, the ultimate driver to stock price appreciation. It is easy to
find the earnings-per-share on the face of the income statement. In general, earnings
should be growing ten percent a year or better each and every year. On average, you
should want earnings to be growing in the mid-teens or better, but even the best
companies in the world will have a slower growth year every now and then, especially
during a recession. But when a company grows (at any rate) through a recession, it is
clearly showing its strength. An accelerating rate of earnings growth is preferable to a
declining rate of growth. For instance if two years ago, Company A grew earnings-per-
share 12 percent, and then grew in the last year by 14 percent, then earning growth is
accelerating. But how can it be determined if earnings are expected to accelerate in the
next year? Many websites and service providers sell earnings estimates and revisions.
Yahoo Finance even makes some basic earnings estimate information available for free
on http://finance.yahoo.com. Just type in the company’s ticker symbol and click on the
“Analyst Estimates” tab. In the “EPS Trends” box you will find the estimates for the
current and next fiscal years. Historical earnings per share can be found on the
company’s income statement in its 10K filing. Calculating the annual changes in
earnings per share will indicate if growth is accelerating or not. The EPS Trends box in
the Analyst Estimates tab also shows the trend in earnings estimates for the past ninety
days. A trend of increasing estimates is preferable to a trend of declining estimates. In
the “Growth Est” box of the Analyst Estimates page the forecasted five-year growth rate
in earnings is also indicated. While the five-year growth rate figure is helpful to
understanding the longer term outlook for a company, it is not as important as the current
and next year estimate changes and the revision trend in estimates (the indication that
estimates are rising or declining).
Steps 1 through 5 are the primary checks that should be performed on every stock. If the
potential investment passes those tests, steps 6 through 8 can provide further insight into
the company.
Step 6. Is the company a leader and gaining market share? A leader is a company with a
top-three market position in its industry niche. It is preferable to own the number one or
two players, but in highly fragmented industries the number three position can still be
okay if it is gaining market share. A leader for alligator investment purposes is also a
company that is growing its sales and earnings faster than its competitors. In fact, it is
more important that a leader be outpacing its competitors than being the largest. In the
1990’s Dell was the leading personal computer company. Its direct selling distribution
model gave it a low cost advantage over competitors. Dell exploited this advantage to
gain market share and create a dominant company. But Dell’s competitors then
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responded, especially Hewlett Packard. Hewlett Packard always maintained a reputation
for quality products, but its cost structure was not competitive. Under new management,
Hewlett got its cost structure under control and reinvigorated its sales and marketing
efforts. It not only stopped its market share losses, but started to regain share and has
been the new leading stock in this industry for the past few years. Sticking with the
leaders is important, but it is also important to monitor their progress to ensure that they
remain leaders. The best check for this is to determine that their sales and earnings
growth is faster than their direct competitors.
Step 7. Is management focused on building shareholder wealth? You want management
to be on your side and to be motivated to prudently grow the company’s earnings.
Charlie Munger, Chairman of Wesco Financial Corp. (an 80% owned subsidiary of
Berkshire Hathaway) and long-time partner with Warren Buffet, has spoken repeatedly
about the power of incentives in motivating human behavior. The second half of “Poor
Charlie’s Almanac” contains a compilation of speeches that Mr. Munger made during his
illustrious career, and is highly recommended for investors and business professionals.
Reviewing a company’s annual proxy statement gives a feel for management’s incentive
structure. The proxy statement includes tables detailing executive managements' salaries,
bonuses and equity (stock options and/or restricted stock) compensation for the past three
years. It also includes a discussion of how annual cash bonus and equity compensation
awards are made. Most of the time, the discussions are vague, but occasionally some
good detail is given. Finally, the proxy statement lists executive officers and their total
insider ownership in the company. There is no set rule for how much executive officers
should be paid in cash and stock. What is relevant is the overall reasonableness of the
policies, and that policies appear to be fair in motivating executives and not be excessive.
If the company had a poor earnings growth for the past three years, a steep drop in the
annual bonus awards should be expected. If that is not observed, that means incentives
are misaligned.
With regards to equity compensation, it is preferable that management receive stock
options, not restricted stock. Restricted stock awards became more popular after the
bursting of the technology bubble at the turn of the century. It was partly a backlash
response to the excessive stock option granting practices by high-technology companies,
which were creating overnight millionaires in businesses that had no real long-term
sustainability. Switching to restricted stock was a clever way for managements of mature
companies to reward themselves more handsomely while appearing to be concerned with
shareholder interests. Most of the supporters for restricted stock came from large mature
companies who had entered in their slow growth phases and had seen the majority of
their shareholder value creation long past. More support came from compensation
consultants who could latch on to the public’s negative sentiment caused by scandals
including Global Crossing and WorldCom; or jealous accountants who have lately
become more concerned with creating complex financial reporting rules rather than
making financial statements more meaningful to shareholders.
Why should investors prefer management receive stock options instead of restricted
stock? Because unless the company’s stock price goes higher, the options that
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management receives will expire worthless. If management is unable to deliver real
shareholder value in the form of a higher stock price, then the stock options they receive
will pay them precisely the right amount for that lack of service … nothing! However, if
management was paid in restricted stock, they get to keep the value of the stock received
even if they don’t grow shareholder wealth. Restricted stock in most cases is just a gift to
executives. The vast majority of restricted stock grants have no requirements for
management to achieve business performance metrics. If executives avoid being fired,
the restricted stock grants will accrue to them free and clear. It does not matter if they
built shareholder wealth. Frankly, that is not much of an incentive!
Options on the other hand are worth something only if management can grow the firm’s
value. While stock options provide a better incentive for management than restricted
stock, excessive option granting at the expense of existing shareholders is not condoned.
Excessive stock option grants create the wrong kind of incentive in the form of short-
sited thinking to drive a stock price artificially high, providing for a quick cash-out by the
option holder. It gets management thinking more about how they will make themselves
rich rather than rewarding all of the company’s stakeholders; including public
shareholders, employees, customers, suppliers and others. As a management focuses
more on short-term performance, it can inadvertently destroy the long-term opportunity.
An example of short-sightedness would be to make a series of acquisitions to boost
earnings-per-share, but paying too much for them. As a general guideline, it is preferable
to see option grants limited to 10 percent of a company’s earnings growth rate. For
example, if XYZ Company’s objective is to grow its earnings-per-share at a 15 percent
long-term rate (and if that is reasonable assumption), then stock option grants should be
limited to 1.5 percent of Company XYZ’s current outstanding stock. If XYZ Company
has 50 million shares outstanding, then stock option grants in any year should be limited
to 750,000 options.
Small and midcap size companies tend to grant options in the range of 2 to 3 percent
annually. That should be expected. Smaller companies tend to be faster growing and can
afford to grant more options in order to attract executive talent. Additionally, executives
and other employees joining smaller, riskier companies need a proper incentive to be
lured away from their existing employment. But as a company grows in size, its growth
rate will naturally slow. As it slows, so should the level of stock option grants. It is only
logical that people are not taking the same level of risk by joining an organization when it
is larger and more established, and they should not receive the same proportion of equity
compensation as those employees who joined in the infancy and adolescent stage. If a
company is consistently granting more than 3 percent of the shares outstanding to
employees every year, it is an insight into its management’s culture as to how they think
about themselves versus shareholders.
Step 8. Are there accounting shenanigans? A company’s financial statements should be
fairly straight forward and simple to understand, especially for smaller companies which
typically are focused on only one business as opposed to conglomerates like General
Electric which are a collection of multiple businesses and highly complex. The United
States has the best regulatory and most transparent accounting practices in the world.
37. 37
This means that investors in U.S. companies get a clearer look at just how a company has
performed. A company’s financial statements can give you some insights not just into
the business results, but also into how management thinks and whether they are
conservative straight-forward people, or if they are aggressive and overly risky with
shareholder capital. Financial statements can also give clues about management trying to
hide information about the company by placing it in the footnotes rather than on the face
of the financial statements.
One of the most important tests for accounting shenanigans is simply checking the “cash
flow from operations” versus net income, and a company’s ability to generate free cash
flow. This was covered above in Step 2 separately. In performing this step, keep a
watchful eye for sudden increases in accounts receivable or inventories that are
disproportionately larger than the increase in sales. A sudden spike in receivables may
indicate management is offering easier credit terms to customers in order to drive short-
term sales. It could be an indication of “stuffing the channel,” a practice used by
companies to make short-term sales goals in the hope that demand will pick-up later to
clear inventory forced down to its customers. Spikes in inventory may indicate that
management has overestimated demand for its products and may have to take future
write-offs and markdowns in order to clear inventory.
Read (or at least scan) the footnotes in the financial statements for joint ventures and
other forms of off-balance sheet financing. Aggressive managements will often try to
hide losing or less profitable ventures from the face of the financial statements. They do
this by setting up joint ventures in which they have a minority ownership. Often times
the majority owners of the joint venture are in some way related to the company. By
doing this, a company can inflate its reported results. Take the example of a Research &
Development joint venture (“R&DJV”). The R&DJV performs research for the benefit
of the company to develop a new technology. Because the company only owns a
minority interest in the R&DJV, it does not have to show the full cost of the research on
the income statement, which effectively overstates earnings-per-share. If the research is
successful, the company will often have an option to buy out the majority shareholders of
the R&DJV at a determined “fair value.” You can be sure that value will be fair to the
R&DJV majority interest-holders, but it is probably less fair to you as a shareholder of
the company. If the research is not a success, the company is most likely guaranteeing
the obligations of the R&DJV, and ultimately you (as a shareholder in the company) end
up footing the bill anyway.
Joint ventures are also used to move debt off the balance sheet in order for the company
to give the appearance that it has a more sound financial position than economic reality.
Essentially, debt is loaded on to the minority-owned joint venture, but the company
ultimately guarantees the debt. It’s nothing more than smoke and mirrors. Aggressive
managements will always try to find ways around accounting rules. When financial
statements include footnotes about joint ventures, debt guarantees and off-balance sheet
financings, it should raise a red flag … especially if these also involve transactions with
related parties. These are indications that management is more interested in making
themselves money at the expense of the public shareholder.
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Other footnotes in the financial statements that should be read are the “commitments and
contingencies” footnote, and footnotes related to pensions and other post-employment
retirement benefits (OPEBs). The commitments and contingencies footnote is where a
company lists lawsuits, guarantees, purchase obligations and other issues that impact
claims on future cash flows. This should be a short footnote … maybe just a couple of
paragraphs. If it starts to run more than one page, be wary! With regards to pensions and
OPEBs, keep in mind that these represent future liabilities for the company. If the
company is not taking proper actions to fund obligations today, they could be a burden on
the future cash flows and earnings. Look at all the trouble the automobile manufactures
and airlines companies ran into because of the burden placed on them by their under-
funded pension obligations.
Finally try and avoid companies with complicated capital structures. If the company
makes extensive use of convertible debt, multiple classes of stock, option strategies
(warrants, puts and calls) on its own stock in managing the capital structure; then
investing in that company should generally be avoided. Management should be focused
on running the business, not on playing with clever financing structures. Convertible
debt by itself is not enough to avoid a company. In many ways, it is an excellent way for
a company to raise capital at a cost-effective rate. What investors need to be wary of a
company that seems to be serially hooked on complicated financing structures and
potentially gaming its own stock. Recently, SLM Corporation (more commonly known
as Sallie Mae) had to raise capital because it lost over two billion dollars of shareholders’
money when it bet the wrong way on future exchange contracts involving its own stock!
SLM Corporation is in the business of lending to students working on advanced degrees,
not managing shareholder capital through hedge fund-type activities. Monkeying around
like that with shareholder capital is nothing more than shenanigans, and should be
avoided.
In summary, investing in a company should not be overly complicated. By sticking with
reputable managements that are running straight forward, profitable businesses, growing
their earnings-per-share that are backed up with real cash flow; the alligator investor will
be well down the path to successful investing. Appendix A includes a list of fundamental
research questions that can be used to help evaluate most companies.
