David

Performance Review and Related Thoughts (The First 5.5 Years)

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From the Closing Thoughts of the January 2023 FALCON Method Newsletter (published on 08/01/2023)

The numbers are in. As usual, in the January issue, we take a look at how our FALCON Portfolio has performed relative to some benchmarks. To make this comparison fair, we had to ditch Old School Value’s (OSV) calculator and switch to Portfolio Visualizer Pro. While I now consider this latter tool the golden standard of performance evaluation (mainly because of its transparency), OSV’s solution served us well through the years.

The reasons for switching were plenty: (1) Eaton Vance got acquired, and its ticker symbol ceased to exist, which OSV couldn’t properly handle. (2) OTC stocks are not supported by OSV, so we had to find a workaround for including Tencent in our modeled portfolio, just like we had to come up with a creative solution to address the Eaton Vance issue. The more tinkering it required, the less reliable the results became. (3) OSV seems to be applying daily rebalancing when modeling an equal-weighted portfolio, and that frequency is simply unrealistic. (4) Last but not least, dividends are added to portfolio returns in OSV, but it cannot handle dividend reinvestments, which significantly distorts long-term results when compared to total return indexes (that benefit from the impact of continuously reinvested dividends). All in all, Portfolio Visualizer Pro transparently shows that the newsletter’s performance may have been underreported until now, mainly due to reason #4. 

Without further ado, our FALCON Portfolio’s value decreased by 13.2% in 2022, outperforming both the S&P 500 (-18.1%) and the MSCI World (-17.7%). This is no surprise since our defensive strategy tends to lose less when the market falls, thus preserving a higher base to build on once the tide turns. Of course, defensiveness also means we are not capturing 100% of the upside amid euphoria, but the numbers do work out over cycles. (More specifically, we have a downside capture ratio of 96.4% and an upside capture ratio of 98.5%.) Since inception, our newsletter’s equal-weighted portfolio has produced an annual return of 11.0%, compared to the S&P 500’s 10.7% and the MSCI World’s 8.1%. All figures include reinvested dividends. You can see our report card below, showing all our monthly, annual, and cumulative returns. (The numbers speak for themselves; not that I was too interested in the monthly breakdown.)

Click to enlarge!

I consider the interpretation much more important than the outcome, so allow me to spill some virtual ink on this topic. I have long said, and results do prove that our investment strategy is defensive in nature, so we expect to generate most of our alpha during down markets. (Those down markets that have failed to materialize for a while.) Check this chart of annual returns to see what I mean.

Some may argue that our EVA Monster focus tilts us toward a more aggressive approach, and it has most certainly increased our downside capture ratio. Yet I want you to understand that our quality-growth picks are highly profitable companies with enviable market positions. Consequently, we are not investing in your typical speculative growth stock that not only got slaughtered as yields rose but may have trouble regaining footing until turning profitable and cash flow positive. All in all, I’m happy with the blend of two stock types in our portfolio: dividend-paying Fallen Angels and quality-growth beasts that go by the EVA Monster name.

When it comes to performance evaluation, a not-too-often quoted piece by Bill Miller may be thought-provoking. In his 2005 letter, Miller writes: “You are probably aware that the Legg Mason Value Trust has outperformed the S&P 500 index for the past 15 calendar years. That may be the reason you decided to purchase the fund. If so, we are flattered, but believe you are setting yourself up for disappointment. While we are pleased to have performed as we have, our so-called ‘streak’ is a fortunate accident of the calendar. Over the past 15 years, the December-to-December time frame is the only one of the twelve-month periods where our results have always outpaced those of the index. […] We would love nothing better than to beat the market every day, every month, every quarter, and every year. Unfortunately, when we purchase companies we believe are mispriced, it is often difficult to determine when the market will agree with us and close the discount to intrinsic value.” The only reasonable goal can be to construct an investment portfolio that has the potential to outperform the market over entire business cycles.

And were I not a newsletter provider, I wouldn’t even bother about outperforming any benchmark. By all means, please read Morgan Housel’s “Internal vs. External Benchmarks” post to get the message. Just a short quote, as I guess that 99% are not clicking on any links: “The only way to consistently do what you want, when you want, with whom you want, for as long as you want, is to detach from other people’s benchmarks and judge everything simply by whether you’re happy and fulfilled, which varies person to person. I recently had dinner with a financial advisor who has a client that gets angry when hearing about portfolio returns or benchmarks. None of that matters to the client; all he cares about is whether he has enough money to keep traveling with his wife. That’s his sole benchmark. ‘Everyone else can stress out about outperforming each other,’ he says. ‘I just like Europe.’ Maybe he’s got it all figured out.”

Turning to the macro picture, 2022 was undeniably dominated by the Federal Reserve’s actions to fight inflation. The latest 0.5% increase was anticipated, but the expected terminal rate of 5.1% (equivalent to a target range of 5%-5.25%) by the end of 2023 moved up from the 4.6% projected by the Fed back in September. As things stand, seven central bank officials expect rates to go even higher, with two seeing rates topping out at 5.75%. One hawkish official expects rates to remain at that level through 2025. Chairman Jay Powell said it was impossible to know if a recession would occur, and if one does, how long it would last or how deep it would be.

I believe the stock market has been focusing on an optimistic inflation scenario throughout 2022, yet defensive sectors have performed well. This may change quickly if the outlook begins to improve. I read that in the latest Barron’s poll of Wall Street strategists, not one 2023 target suggests a loss in the S&P 500 over the coming year. The average year-end target for 2023 is above 4,200, with both the median and average target implying a 2023 total return of over 10% for the index. I’d be itching to hear the expert explanations, given that valuations at the top in early 2022 were higher than those of 1929 and 2000, interest rates are significantly higher than any period from 2009 to 2022, and inflation is higher than any point in the last 50 years. With that being said, our FALCON Portfolio is an all-terrain vehicle that will serve us well whatever comes in 2023 and beyond. Be patient, stick to the plan, and enjoy every minute of the journey!

New to the FALCON Method? Check out how our investment process works: How to Build an Evidence-based Stock Selection Process in 7+1 Steps

 

The 5 Steps of the FALCON Method

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***UPDATE: As the FALCON Method kept evolving, this post got updated. You can read the latest version here.***

Identifying the quality stocks that are on sale can be easy if you have an evidence-based system to help you. The FALCON Method is an all-round investment process that relies on the principles of value investing, common sense, and quantitative discipline. The goal is to construct a buy and hold portfolio with a focus on both income and total return. All the steps are backed up by factual evidence as you’ll see below.

“If you can’t describe what you are doing as a process, you don’t know what you’re doing.” W. Edwards Deming

1: The Quality Criterion: Go for the true and tried!

Common sense idea: Only invest in top quality companies that have stood the test of time. These businesses have great internal economic fundamentals and long-term track records for performance and excellence.

 “Time is the friend of the wonderful company, the enemy of the mediocre.” Warren Buffett

As a long-term investor aiming for wealth building and reliable passive income, you should go for the wonderful companies instead of the mediocre ones.

Rule: Stocks must have at least a 20-year immaculate dividend history–meaning no dividend suspension or cut–to qualify. If a company has been able to pay growing dividends for decades, it’s a sure sign of its consistent earnings power. Taking this argument one step further, it is no surprise that companies with these characteristics tend to outperform.

“The importance of dividends in generating stock returns is not just historical happenstance. Dividends are the crucial link between corporate profits and stock values.” Jeremy Siegel

Evidence: The Dividend Aristocrats (stocks with 25+ years of rising dividends) have outperformed the S&P500 over the last 10 years by a considerable margin. (Source: us.spindices.com/indices/strategy/sp-500-dividend-aristocrats)

For further evidence read the book: The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New by Jeremy J. Siegel

Here’s a short summary of the findings:

“We have also examined the 10 highest-yielding stocks among those that have not reduced their dividend in the last 15 years. A period of 15 years was chosen because that means the firm must have passed through at least one recession. Managements that have not cut their dividend have demonstrated the consistent earning power and strength of their corporations.” Prof. Siegel found that these group of stocks tends to outperform. This simple strategy had a 15.68% annual return between 1957 and 2003 vs. the 11.18% of the S&P 500.

We need a long dividend history so that we can test how the company’s management behaves when things get tough. Siegel uses a 15-year timeframe, while the FALCON Method goes for 20 years of immaculate dividend history. Notice also that the professor simply picked the highest yielding stocks from his select universe, while the FALCON Method uses a multi-faceted approach (the components of which are all proven).

2. The Value Criterion: Buy them on the cheap!

Common sense idea: Everyone loves bargain purchases. Buying top-quality stocks at low prices not only feels good but also leads to superior investment returns. Bargains are temporary as prices rise in the long-run (boosting our returns) to reflect the underlying quality of the businesses.

“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” Warren Buffett

Rule: Take a multi-dimensional look at valuation. Use indicators like Price-to-Adjusted Operating Earnings, Price-to-Operating Cash Flow, Price-to-Free Cash Flow, Price-to-EBITDA and examine their historical averages in multiple time frames. Compare the current valuation ratios to the historical averages and make sure that the current level reflects a fair or better price. If you buy top quality stocks at below-average valuation the powerful force of mean reversion is on your side. (Valuation ratios tend to move back toward the mean or average and this multiple expansion helps your investment returns.)

Evidence: Look at the performance stats of the S&P 500 Pure Value Index and the MSCI World Value Index and see that value investing outperforms in the long run.

We also have historical proof showing the outperformance of the individual factors used. When examining the tables below, please notice that the longer the holding period the higher the probability of outperformance is with all the factors.

Price-to-Earnings type of indicators:

An example, and your key to understanding these tables: If you pick 10-year holding periods from 1964 to 2009, the most attractively valued tenth of stocks (the Earnings/Price Decile 1) outperformed the market 99% of the time. The average annual excess return was 4.63%. All the tables below should be read in the same way.

Price-to-Cash Flow type of indicators:

There was not a single 10-year period in the sample when the most undervalued tenth of stocks (based on cash flow to price) did not outperform the market.

And the same is true for the EBITDA metric below.

Using these proven indicators to gauge valuation levels and going for the historically undervalued quality stocks tilts the odds of success in our favor.

3. The Threshold Criteria: Are you getting paid enough?

Common sense idea: For every dollar you invest you want to get the most possible money in return. Under a certain threshold, you are not that keen to invest your capital at all.

Rule: Compare the price you pay for a stock to the amount of Free Cash Flow the company produces per share (FCF yield), the money it returns to its shareholders through dividends and buybacks (shareholder yield), and the dividend it pays (dividend yield). Taking the prevailing market conditions into account, set absolute minimum requirements for these three and only consider a stock worthy of your money if it meets all these three criteria.

Evidence: The selection of the three indicators is logical since you demand that the company produces surplus cash, returns some of it to the shareholders, and makes dividends a considerable part of these returns. Besides being logical this selection is also evidence-based. See below, how all of these factors support outperformance.

Price-to-Cash Flows, again:

The shareholder yield as a strong factor:

For additional evidence on this metric read the book Your Complete Guide to Factor-Based Investing by Andrew L. Berkin and Larry E. Swedroe. The authors elaborate on how investing in the stocks providing the best shareholder yield has outperformed both the market and the simple dividend-yield strategy in three out of the past four decades.

The dividend yield also deserves a place in our system but it wouldn’t be enough on its own!

James P. O’Shaughnessy finds in his book What Works On Wall Street that the dividend yield becomes much more powerful as a factor if used with a select group of quality dividend paying stocks only (instead of all the stocks on the market). Exactly how the FALCON Method does it.

4. Yield Plus Growth: A multifactor ranking for maximizing total return

Common sense idea: All things being equal, the higher dividend and the higher dividend growth you get for your money, the better. Your total return is determined by three components: the starting dividend yield, the growth of the underlying company, and changes in the valuation multiple. (The latter has been taken care of in the second step of our process.)

Rule: Rank the stocks that survived the previous steps based on yield-plus-growth characteristics. Instead of using an oversimplified indicator like the popular Chowder number employ a weighted multifactor quantitative ranking with yield-plus-growth numbers of different time frames. The higher the yield-plus-growth rank, the better.

Evidence: Stocks of companies that keep growing their dividends tend to outperform. (Source: Oppenheimer)

Additional evidence about the relevance of dividend yield and growth:

Why Dividends Matter (Guinness Atkinson Funds)

Reasons to Consider Dividend-Paying Stocks (Dreyfus)

Dividends for the long term (J.P. Morgan Asset Management)

5. Sleep Well At Night: The finishing touches

Common sense idea: No matter how good a stock looks in a ranking system if you don’t feel comfortable investing in it you will have a hard time holding on when panic erupts. Only buy stocks that you intend to hold for the long-run.

At this point, rules have already played their part and human judgment comes into play. No matter how much one prefers quantitative methods some things simply cannot be quantified, filtered, and ranked in an automated way.

A few examples: Cyclical and non-cyclical stocks should be evaluated differently, while certain sectors have their specific metrics (like REITs). I would never sleep well without having a thorough look at how well the company employs its capital (I am looking for consistently high return-on-invested-capital) but I wouldn’t rank and eliminate firms based on this metric alone. Last but not least, I am also calculating what total return I can expect from the investment based on very conservative assumptions about growth and valuation multiples. This is a time-consuming and knowledge-intensive step that is only carried out with the stocks that seem to deserve it.

As a result: The FALCON Method gives the list of Top 10 stocks that best fit the “quality merchandise on sale” description in any market environment. I also like to highlight my Top Picks from this list every month that may not be the stocks that are ranked highest since not all the qualitative factors are represented in the scoring system.

+1: When to Sell?

This is a buy and hold approach so selling occurs rarely; only when a stock becomes extremely overvalued, or if it reduces its dividend. A dividend cut means that the investment theme is broken and action must be taken since dividend cutters tend to underperform.

“When the facts change, I change my mind. What do you do, sir?” John Maynard Keynes

Source: Dividends for the long term (J.P. Morgan Asset Management)

While a dividend cut is a clear sign, extreme overvaluation cannot be identified by a single metric like a P/E above 40. I always look at the historical ranges of the dividend yields and various valuation metrics and I only push the SELL button (and send out an alert about this decision) if most of the indicators point towards that direction. Stocks that became overvalued have subpar total return potential as the data shows so there is no reason to hold them.

Source: The Case for Value by Brandes Investment Partners

How to use this info?

You can get the ready-to-use stock picks of the FALCON Method straight to your inbox every month if you give the Newsletter a try. Currently, there is a 7-day free trial, so you are truly not billed for 7 days. Have a look at the newsletter and if you don’t like it, just email me at david@thefalconmethod.com within the first 7 days and you can opt out without paying anything. If I were you, I would use the discount code that is included in this free guide to get the best deal.

The newsletter comes with an easy-to-use one-page summary and it also includes the detailed analysis of the Top 10 stocks. You have everything there to start building your portfolio.

If you have questions, email me and I will reply to you personally, in most cases within 24 hours.

Want to learn more about the FALCON Method before giving the newsletter a try? Check out the book!

Get my FREE Guide on Investing!

Discover how to build passive income and wealth with the confidence that evidence-based investing can give you.

This one habit changed my life!

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When I made the decision to become an investor and aim for reaching financial freedom through investing I knew I had a lot to learn. I decided to read at least one hour per day. This is exactly what Brian Tracy recommends. He says that picking the topic that interests you and devoting a single hour per day for reading about it will raise your level of knowledge to such a degree that within a few years you will be regarded as one of the experts on your chosen topic in your country. It’s so true! This single habit has changed my life but it was not that simple in the beginning.

When you start out reading and have no background knowledge you will notice that some reputable authors (investors is my case) are contradicting each other. I always take notes and after the first 10 books I felt puzzled because one of the top investors said A and the other one said B, the exact opposite. I had absolutely no chance to tell which of them was right so all I could do was to move forward: read, read, read and get some own experience so that things would start to crystallize at a later stage.

I’ve been reading 50-70 books per year for several years now. Besides taking notes I also devoted long hours to sitting in front of a blank piece of paper and trying to put together, synthesize what I have learned. This painful and long process led to the birth and fine-tuning of the FALCON Method. If you want to become a do-it-yourself investor, the best advice I can give you is to start reading today! Warren Buffett reads 5-6 hours a day and he is one of the best investors on the planet. This is no coincidence.

What should you read?What if I told you there is a book that distills all I learned and makes it available to you within a few short hours instead of the years I had to put in? Would it be a good start? Hundreds of books and years of experience condensed on 130 pages, this is what the FALCON Method book offers. (I certainly could have used such a book to steer clear of some of the most expensive ‘dead end adventures’ of my investment journey like microcap investing or highly leveraged trading.)  Save time and get your attention focused on the factors that really determine your returns.


Check out the book on Amazon!

Don’t forget: whenever you start out in a completely new field, you will feel the lack of confidence that is absolutely normal! The best you can do is to shorten this initial timeframe by learning from someone who has been there, done that.

Question: What is your favorite book? (Doesn’t have to be investment related.) My Amazon wish list is growing at an extraordinary pace so please, show no mercy: send me your book recommendations!

Are you a trader or investor type? A comparison I bet you’ve never seen

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There is no ‘one size fits all’ solution to reaching financial freedom so I am ready to admit that the FALCON Method is not able to help everyone. In this post I want to highlight the major differences between two approaches: trading and investing. As a result you’ll get an idea which might fit you better and whether you should utilize the FALCON Method.

Those eye-catching ads about quick profits

You must have seen tons of ads that want to convince you to become the next ‘forex superhero’. One thing these have in common is that they are advertising some insane rates of return suggesting that you could get very rich overnight. Are those rates achievable? For some lucky few and for a short sample period: SURE! The problem is that the percentage of people who can consistently make spectacular returns by trading is very low.

In fact I had the chance to see one of these companies from the inside and the percentage of successful clients was in the low single digits! They told me it was the standard level in their industry. What about the rest of the people? The typical client deposited some money which he lost within the first few months of trading. Certainly not the story they signed up for… and this is the reason why these companies have to advertise aggressively: their newly acquired clients’ account balances are converging to 0 at a very rapid pace.

What if you calculate an expected return for trading?

Say that a successful trader makes a 50% annual return on his account balance consistently. I deliberately overstate this figure to illustrate my point. Now say that 5% of the ‘wannabe trader superheroes’ succeed in this quest and the rest of them loses his account balance on the way. (This is a huge simplification, again for the sake of illustration.)

Based on these assumptions the expected return of trading would be the 50% expected annual return multiplied by the 5% probability of reaching it. This amounts to 2.5%. You have never seen such a calculation in those shiny ads, I bet! I encourage you to use your own assumptions as inputs and do your own math.

Why is the failure rate so high?

Mainly because of our inborn psychological biases. The way our brain is wired helps us survive but these same instincts are not the best for stock market success, to say the least. Most people cannot handle the constant stress and decision making that is required for trading success and they fail. The higher the number of decisions you need to make the higher your emotional involvement and the level of stress can be. Trading is not a calm pastime activity for most people. Far from it…

What about investing?

Investing involves long-term commitment. You do not buy some stocks with the intention of selling them within a few days or a few dollars of price movement.  Instead you identify quality stocks that are available on the cheap, buy them and let your money work in them as long as the company is doing its job. Have you read the case study of my Cracker Barrel investment? You can see that this approach is not that stressful and hardly involves decision making after a thoughtful purchase.

This means that the psychological burden of investing is much lighter than that of trading and this translates to a significantly higher success rate among the people who choose this way.
Let’s say that a good investor can achieve a 10% annual return consistently and 50% of the people are capable of doing this. These assumptions would lead to an expected rate of return of 5% that is the double of what we got with the trading scenario. (Don’t let these absolute values freeze you since they are totally meaningless on their own! Again, use your own numbers, I just wanted to give you a framework to think.)

I strongly prefer the low-stress way of achieving great returns with the odds on my side to living a stressful life with the ill intention to get rich quick while fighting against the odds.

As a summary: the FALCON Method will work for you, IF…

  • You think long-term.
  • You have a “saver and investor” mindset.
  • You want performance, not excitement. (This is not an adrenaline-packed trading system but an evidence-based long-term investment strategy. The difference is night and day.)
  • You favor a “trust but verify” approach and want to see for yourself why the FALCON Method has very high probability of superior performance.
  • You are able to stick to a strategy and do not deviate from it.
  • You appreciate that you do not have to devote your whole life to learning and practicing investing.
  • You appreciate transparency and total honesty.

The good news is: there are no more IFs. Absolutely no qualifications, inborn talents or special skills are necessary. Once you feel your mindset fits most of the above criteria, you have found what you are looking for.

“Investing should be like watching paint dry or watching grass grow. If you want excitement…go to Las Vegas.” Paul Samuelson

How I made 96% profit with a system you can easily replicate

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This story started in May 2014 when I received a free dividend newsletter full of eye-catching titles. I was subscribed to all the free stuff on the internet at that time so I really had to filter out the noise if I wanted to keep my life together and not spend all the day with my inbox. Most of the time all I did was to scroll through such newsletters in a few moments and I hardly ever clicked on any of the articles included.

This time a title said that a company I’ve never heard of (Cracker Barrel) increased its dividend 33% but the market failed to notice it and the stock price had hardly moved. This grabbed my attention and I thought to myself: why not have a look at this story? I had a very simple investment process back then and I wanted to check how well this company fit. Here’s what I focused on.

This was the 12th annual dividend increase from Cracker Barrel in the previous 12 years which showed me that the management was serious about returning money to the shareholders. This dividend history clearly signaled that the willingness to pay a dividend is most certainly there

As a next step I wanted to explore how much cash this company was making so that I could gauge how safe the dividend seems to be. I came up with some quick and easy calculations the summary of which you can see on this chart:

At this point I started to become interested, since Cracker Barrel seemed to have a very well covered dividend, a decent history of paying and had just raised the dividend by 33% which told me that the management was more than optimistic about the company’s future. (So not only the willingness but the ability to pay was there as well.)

The stock’s current yield was above 4% that was much higher than the market average that time, and this 4% was most certainly higher than the average dividend yield of Cracker Barrel. The following chart told me I may have an opportunity for a bargain purchase here.

The dividend history was OK, the coverage was more than adequate, the current yield and the growth rates were spectacular and the stock seemed to be cheap in historical comparison. I pressed the BUY button at a price of $95.31.

And now comes the boring but profitable part of the story. This Cracker Barrel did nothing but kept raising its regular quarterly dividends and paid me a special dividend annually as well. The table below shows that by the beginning of August 2017 I will have recuperated more than 25% of my original investment in the form of dividends.

Since the total return has a price and a dividend component as well it is time to look at the stock price. At the time of this writing Cracker Barrel trades at $163.3, which means that I am sitting on an unrealized profit of 71.4%.

My plans for the future? As long as this company keeps raising its dividends and is paying me nearly 9% of my initial investment every year (regular and special dividends combined), I see absolutely no reason to sell. My investment method is about buying right and holding onto my cash cows thereafter until they become extremely overvalued. Cracker Barrel is far from that level at the moment so I’m in for some calm and lucrative dividend harvesting.

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Investing was my most expensive hobby! Learning these 4 lessons made the change

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When I started out in investing (in my 20s) I was nothing special. I had no confidence, no extra knowledge, just a burning desire that I wanted to get my money to work and produce passive income so that I could leave the work I didn’t like. (I was running my own company which made things more complicated. On one hand I had the money to invest, on the other hand quitting your own company is not the easiest of things.)

Lesson 1: Your financial status and level of knowledge always converge.

I was a guy with a relatively low level of investment knowledge and a high amount of money to put to work. “A fool and their money are soon parted” you know. Since getting my knowledge level up was not a short process, but the money part of this equation could move much faster, the result was that I’ve lost plenty of money with various investments during the years I was building up my knowledge. (Money level moving quickly downhill, knowledge level slowly climbing up… it was utterly painful until the point these two met somewhere in the middle.)

For the sake of illustration: I invested in exotic property (a hotel in Thailand to be more exact that was really hard to sell), a sheep farm (lawsuit still in progress), forex robots (all of which lost money), some outright Ponzi-schemes (most of the perpetrators are in jail), startup companies (with dishonest partners) and stocks of disastrous public companies. My journey to success was very long, painful and expensive. In fact, investing was a very expensive hobby until I figured out how to do it right!

At some point, I found an investment newsletter many people were raving about. Its title even included the magic word “dividend” and I thought my savior arrived: a guy who knows how to pick stocks that would provide the passive income I so desire. I subscribed to his newsletter and at first I felt somewhat uncomfortable with his recommendations. By this point I have read tons of investment books but I was very far from coming up with my own system, so I just suppressed my feelings and followed this ‘expert’.

One of the stocks he got me to buy was Transocean (RIG). I never really understood his reasons behind this purchase since this didn’t look like a safe dividend stock to me and he was very secretive about his stock picking system. Long story short: the company stopped paying dividends and the share price fell from $38 (where I bought) to single digits. That really hurt! This was the wake-up call I needed.

I started thinking. (Better late than never…) What do all my failed investments have in common? In most cases I totally relinquished control and didn’t fully understand how these investments worked and could make money. All the guys selling these investments were sales and marketing superheroes, their confidence seemed to be sky-high (compared to mine at that time), but the actual results I got were woeful.

Of course the newsletter guy kept smiling, dusted himself off and went on to get new subscribers to fill the void left by the ones whose financial lives he managed to ruin. Following his recommendations was very stressful for me since I didn’t understand the underlying logic so I didn’t have a conviction about any of the stocks that landed in my portfolio. Can you imagine how you’d feel if one of your stocks fell by 80% and you knew nothing about the company?

Lesson 2: Relinquishing control over your money never works.

Do you notice the pattern I’ve followed? I tried to escape the responsibility of managing my own money as I found it stressful. What I got in return was more stress and dreadful results. Successful people take responsibility and want control.

Lesson 3: Never invest in anything you do not fully understand!

Keep asking. If you do not get the answers that make you comfortable with the decision, have the confidence to say no and walk away. Looking back, even in my late 20s I knew much more than most people on the other side of my failed investment stories, yet my lack of confidence let them walk away with my money.

Lesson 4: Is it a system, a structured process or just some fancy marketing?

Selling an investment to someone who is not an experienced investor is really easy. A guy with no integrity can always come up with a story that sells. But here’s the catch: can that person describe what structured thought process, what kind of system led him to the investment opportunity he is proposing? Only invest if there is an underlying process you can fully understand. If you keep asking and really want to discover an investment system only the honest guys will keep answering. All the get-rich-quick salesmen will rather go for the easy money and yell: “Next please!”

You most certainly don’t want to be that “next” person. Learn from my mistakes, save years of agony and plenty of money by having the confidence to only invest in something you understand; or better yet: follow a well-structured investment process you understand instead of blindly trusting the sales guys out there. Understanding leads to peace of mind and this is crucial for both long-term results and a quality life.

If you enjoyed the blog post about my crazy investment stories and have a few minutes, let me know what your worst investment was so far, along with the lessons you’ve learned. I read all my emails and I would be happy to hear from you.

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Coke’s Investors Are Swimming Against The Tide

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Summary

  • “Religion stocks are not safe stocks. Irrational faith and false perception of safety come at a large cost: the hidden risk of reduction in the religion premium.” (Vitaliy Katsenelson).
  • Two components of the total return equation are clearly against Coca-Cola investors. The dividend alone will not save them.
  • Buying the stock today is like playing musical chairs and expecting the music to never stop (expecting investors to continue paying a lot for a little).
  • See how Coca-Cola fares according to the FALCON Method.

Coca-Cola (NYSE:KO) is an iconic American company. Most people think it is one of the safest stocks to invest in and this conviction elevates it to religion stock status, meaning chronic overvaluation.

Religion stocks are not safe stocks. Irrational faith and false perception of safety come at a large cost: the hidden risk of reduction in the religion premium. The risk is hidden because it never showed itself in the past. Religion stocks by definition have had an incredibly consistent track record. … It is hard to predict how far the premium will inflate before it deflates – but it will deflate eventually. When it does, the damage to the portfolio can be enormous. -Vitaliy Katsenelson in his book Active Value Investing

Here’s what catches the eye

Coca-Cola is a dividend champion with 55 straight years of higher dividends. Not too many companies of this kind offer a dividend yield of nearly 3.4% these days when the S&P 500’s benchmark level is below 2%.

On the top of this the current yield is well above Coke’s historical average, so it could seem wise to scoop up these quality shares while they are on sale. But are they really on sale or do many investors miss an important point?

Dividend yield of Coca-Cola (KO); Source: FAST Graphs

The dividend is just one of the 3 building blocks of total return

Equity returns come from two sources: stock appreciation and dividends. Stock appreciation is mathematically driven by two variables: earnings growth and price-earnings change. So we have three components of total return: dividends, growth and the valuation multiple. Having already touched on the dividend part, let’s turn our attention to the other two.

The non-existent growth: If you look at the diluted earnings per share and the free cash flow per share data of the last 5 years the best word I can come up with is “stagnant.”

Source: FAST Graphs

The overextended valuation multiple: Currently you need to pay more than 23 times earnings for the shares of a company the growth characteristics of which leave a lot to be desired. Stocks with such a growth profile deserve a P/E multiple closer to 15 based on historical data. Can Coke’s multiple still shoot up to the 30s or 40s? Sure! Why not? But speculating on that would be reckless.

What can go wrong?

Let’s play with the numbers a little bit. Assume that Coke continues to pay its dividend, which seems to be a very safe bet. Assume that the company’s earnings don’t grow, and its P/E ratio declines to 15 (which is far from an irrational level) within five years. In this scenario, turning to the total return equation shows that over this five-year period the investor will receive 3.4 percent dividend + 0 percent earnings growth minus 8.2 percent P/E decline per year = -4.8 percent a year. (If the P/E ratio declines 8.2% every year it will land on 14.99 at the end of our five-year period.)

Now if you find this example too abstract (or shocking), take a look at the calculations below that include analyst estimates and a P/E multiple of 15 at the end of the period. The annualized total return is 0.38% in this scenario. It is really hard to win if two components of the total return equation are against you but you are still swimming against the tide since the dividend is the only factor you focus on.

Let’s see how a well-structured investment process could highlight these problems and prevent you from making a costly mistake!

A quick look at how Coca-Cola fares according to the FALCON Method

The FALCON Method is a structured stock selection process that serves the construction of a buy and hold portfolio with both an income and total return focus. The model is about 90% quantitative and 10% qualitative. The process includes the following steps.

Step1: Narrow down the field of stocks. I focus on a group of stocks that tend to outperform according to historical data. My minimum requirement is 20 years of immaculate dividend history, meaning there are no dividend cuts within this period. Coca-Cola easily PASSES, since it is a dividend champion with 55 straight years of higher dividends.

Step2: Check the valuation. I focus on the stocks that seem to be undervalued historically based on various metrics.

 current3yr5yr10yr15yr20yr
P/E23.121.721.319.619.722.6
P/FCF28.427.424.522.622.226.3
P/EBITDA16.615.515.114.014.115.8

Source: S&P Capital IQ, FAST Graphs

Current figures are based on blended ratios, meaning a weighted average of the most recent actual reported earnings plus the closest quarterly forecast earnings.

You can see from the figures above that the historical averages of these multiples are rather high, showing that the religion premium is absolutely “normal” for Coke. However the current valuation ratios are even higher than the historical averages and investors are paying such prices for a company that has not shown any signs of growth (in earnings and cash flow) recently.

I believe valuation is not an exact science and we should think about certain ranges of these multiples rather than exact levels. However, no matter what glasses I put on, Coca-Cola cannot be categorized as undervalued today, and for my taste it is not even fairly valued. Coke FAILS the test of valuation, so the FALCON Method would not allow me to buy this stock at the current price. (I am still showing you the remaining steps, since they have some important messages.)

Step3: Three hurdles to filter them. I use absolute threshold criteria (dividend yield, free cash flow yield and shareholder yield) to determine whether a stock is good enough to invest my capital or I should pass up the opportunity. I deliberately define low limits with all the 3 indicators, since my experience shows that meeting all 3 low requirements together usually disqualifies a very large chunk of stocks on my list, but leaves just enough of them to continue the analysis. So this is a very tough combined filter in spite of seeming to be a bit lenient on the single factors.

Dividend YieldFree Cash Flow YieldShareholder Yield
3.4%3.6%5.1%

Source: Morningstar, based on TTM data

Most investors find Coca-Cola attractive because of its high dividend yield and immaculate dividend history. However you should notice that the company is paying out nearly all its free cash flow as dividends meaning that the coverage looks awful with a FCF payout ratio of about 95%. I would never invest in a stock offering a 3.6% FCF yield. This is what the absolute hurdles are for and these figures point towards a very clear FAIL at this step as well.

Step4: Rank the survivors. I am using a multifactor quantitative ranking the factors of which are mostly Chowder-like numbers of different timeframes. Coke ranks 114th of the 322 stocks of the FALCON Method – surely not an opportunity I would get excited about at the moment.

Step5: Enter the human. This step involves some qualitative judgment, but it is far from a Buffett-like deep analysis since not too many of us can carry that out at such a level and with that kind of confidence.

Religion stocks often pass the quality test with flying colors, as past success was driven by a strong sustainable competitive advantage. -Vitaliy Katsenelson in his book Active Value Investing

There is no question about the quality of the Coca-Cola Company. Valuation is an entirely different matter. I would not recommend buying Coke at the current levels. The company should either start showing some growth or the price should reflect the no-growth scenario. Until one of these happens, there are much better opportunities out there.

Takeaway

Coke has been commanding a religion premium for ages. Will this continue indefinitely? Buying the stock today is like playing musical chairs and expecting the music to never stop (expecting investors to continue paying a lot for a little). Buying Coke at these levels is more like gambling than investing since two components of the total return equation are clearly against you. The all-round stock selection process of the FALCON Method prevents us from making such mistakes and directs our attention to the most attractive dividend paying stocks in any kind of market.

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Here’s What To Learn From Warren Buffett’s IBM ‘Mistake’

by

Summary

  • Investing the Warren Buffett Way involves a huge portion of educated guesses about the future competitive position of a company.
  • “The difficulty is that we don’t know the factors that predict future sustainable high returns on invested capital.” (Tobias Carlisle).
  • A structured decision-making process built on evidence-based quantitative factors is the best approach to investing unless you have Buffett’s genius.
  • See how IBM fares according to the FALCON Method.

Nobody is infallible. Not even Warren Buffett. He is an extraordinary investor who happily admits to making mistakes and predicts this to continue as long as he lives. This article is not about crucifying him (for something that might not be a mistake at all) but to draw valuable conclusions from his latest comments on Berkshire’s IBM (NYSE:IBM) investment.

Could be a mistake

In 2016 Buffett said his IBM investment “could be a mistake.” He has become much more articulate about his position lately:

“I don’t value IBM the same way that I did six years ago when I started buying, I’ve revalued it somewhat downward … When it got above $180 we actually sold a reasonable amount of stock.”

To understand what has changed we must have a quick look at how Buffett invests.

It’s all about those wide-moat companies

Warren Buffett is constantly looking for firms that have a competitive advantage, allowing them to earn a consistently high return on invested capital. This advantage (the moat around the castle) must be sustainable so as to prevent competitors from invading the company’s market and pushing down profitability as a result.

Investing the Warren Buffett way requires a tremendous amount of industry knowledge and expertise in business analysis. This cannot be achieved without total devotion to lifelong learning.

“I read and read and read. I probably read five to six hours a day.” Warren Buffett

Here’s the problem (for most of us)

Capitalism is all about reversion to the mean. If a company is earning extra-high returns on invested capital, others will be attracted to its field. As soon as the newcomers put some money to work in that lucrative-looking market they can spoil the party by creating an oversupply. (And many other ways.) As competition intensifies rates of return tend to sink.

The problem is that investing the Warren Buffett way involves a huge portion of educated guesses about the future competitive position of the company. This is a really tricky part.

“It’s one thing to note post hoc that some companies did sustain high or low returns on capital over the period examined, and quite another to do it ex ante, or before the fact. The difficulty is that we don’t know the factors that predict future sustainable high returns on invested capital.” (Tobias E. Carlisle in his book Deep Value)

In fact, this is exactly what Warren Buffett seems to have got wrong, at least according to his latest remarks:

“I think if you look back at what they were projecting and how they thought the business would develop I would say what they’ve run into is some pretty tough competitors, IBM is a big strong company, but they’ve got big strong competitors too.”

Existing wide moats can be identified by sustained above average ROIC (return on invested capital). While observing the past is easy there is no easy-to-identify clue as to the future ROIC of a firm.

Even Warren Buffett makes mistakes (after having spent all his life reading) and unless you have his genius for business analysis your chances of predicting the future competitiveness of a company are rather slim. Based on this, paying elevated prices for current high ROIC is an investment strategy you most likely shouldn’t follow. Mean reversion pops its ugly head and takes care of your returns.

How to tackle this problem? An article is only as good as the meaningful and actionable takeaway it offers, so here are mine.

Takeaway for the individual investor

I am most certainly not like Warren Buffett. I am not spending all the day reading quarterly and annual reports simply because I do not enjoy doing that. Fortunately, this doesn’t mean I cannot achieve investment success. Let the man himself address this point:

“So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.” Warren Buffett, 1967

Buffett achieved his highest returns as a mostly quantitative investor before Phil Fisher and Charlie Munger influenced him to form his current style of investing which is not suitable for most of us (lacking Buffett’s extraordinary qualities and overwhelming devotion).

So what do I do?

After reading hundreds of investment books and gaining valuable (sometimes painfully expensive) experience I have figured out the following:

  • A sensible investor should never follow any “guru” (even if he is called Warren Buffett) into any position. Blindly copying, coat-tailing others will make you vulnerable and stressful since you do not know what you are doing.
  • You can never eliminate the uncertainty about a company’s future from investing. However there’s an intelligent way to address this. (Do not create a concentrated portfolio of stocks based on qualitative judgment unless your initials are W.B.)
  • A structured decision-making process is the best approach to investing. I have built my process on evidence-based quantitative factors the combined use of which tilts the odds of superior performance in my favor. Investing is probabilistic and never deterministic, so this “odds tilting” is the best you can do.
  • If you are not devoting your whole life to reading and investing, do not give too much room for qualitative decisions. It is complacent or outright crazy to believe that you will become the next Warren Buffett without making the same sacrifice he has made.
  • Based on the above, I am utilizing an evidence-based investment process that is about 90% quantitative and 10% qualitative. I only let qualitative factors creep in when the field of stocks is narrowed down to such an extent it would be really hard to make a costly mistake.
  • My process serves the construction of a buy-and-hold stock portfolio that is not highly concentrated. This portfolio produces dependable and growing passive income in the form of dividends while also having extraordinary total return potential thanks to the factually proven quantitative factors behind stock selection.
  • I do not have to spend all my time with my investment decisions so I can live a meaningful life while employing a sensible approach to build wealth.

What about IBM in particular? If that stock ranks well in my all-round selection process (which it most certainly does at the moment) then I’m ready to buy a small position for my portfolio. My experience shows that most of these positions tend to work out really well, while only a few of them underperform. Picking stocks with the proven factors of outperformance and reliable dividend stream in mind can lead to great results on a portfolio level. And most importantly, it is a low-stress way: I don’t need to worry that Warren Buffett forgets to give me a ring next time he sells some of his positions I blindly followed him into…

A quick look at how IBM fares according to the FALCON Method

The FALCON Method is a structured stock selection process that serves the construction of a buy and hold portfolio with both an income and total return focus. The model is about 90% quantitative and 10% qualitative. The process includes the following steps.

Step1: Narrow down the field of stocks. I focus on a group of stocks that tend to outperform according to historical data. My minimum requirement is 20 years of immaculate dividend history, meaning there are no dividend cuts within this period. IBM has been raising its dividend for 22 years now, so it passes easily.

Step2: Check the valuation. I focus on the stocks that seem to be undervalued historically based on various metrics. IBM looks to be available slightly on the cheap side of its historical valuation. Not a huge bargain I would say, but the current market does not offer too many quality stocks at fair or better prices. IBM passes this test as well.

 current3yr5yr10yr15yr20yr
P/E11.012.210.411.912.815.5
P/FCF11.612.411.912.913.316.9
P/EBITDA7.78.67.27.67.78.6

Source: S&P Capital IQ, FAST Graphs

Step3: Three hurdles to filter them. I use absolute threshold criteria (dividend yield, free cash flow yield and shareholder yield) to determine whether a stock is good enough to invest my capital or I should pass up the opportunity. I deliberately define low limits with all the three indicators, since my experience shows that meeting all three low requirements together usually disqualifies a very large chunk of stocks on my list, but leaves just enough of them to continue the analysis. So this is a very tough combined filter in spite of seeming to be a bit lenient on the single factors. Again, IBM easily passes.

Step4: Rank the survivors. I’m using a multi-factor quantitative method ranking the factors of which are mostly Chowder-like numbers of different timeframes. IBM ranks 56th of the 322 stocks based on the combined “yield-plus-growth” indicators, yet when all the companies are excluded that fail to pass the three absolute threshold criteria or seem to be overvalued in historical comparison IBM becomes a Top 10 stock in the FALCON Method. (No surprise here: most top quality stocks are clearly overvalued today.)

Step5: Enter the human. This step involves some qualitative judgment but it is far from a Buffett-like deep analysis since not too many of us can carry that out at such a level and with that kind of confidence.

The company is earning high returns on invested capital, its dividend is more than adequately covered and playing with FAST Graphs gives me an estimated annualized rate of return between 8%-12% in the most conservative scenarios. For me, IBM near the $150 price level is clearly not a sell.

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