‘Risk management, when done poorly or not at all, can cost you a fortune’ – Steve Nyvik
My interview with P.J. Pahygiannis of GuruFocus.com
1. What is the best investment advice you have ever been given?
Risk management, when done poorly or not at all, can cost you a fortune. In other words, “Don’t put all your eggs in one basket.” You should diversify away, to the extent reasonable, non-systematic risk (this being company-specific or industry risk).
So for common stocks, we limit the amount of company risk and the amount of industry risk through buying enough stocks which we diversify well by industry (that are not highly correlated to each other).
For example, if we invest the same dollar amount into each of 40 stocks, our risk is that if one company disappears, we’ve lost 2.5% of the value of our stocks. We want them diversified by industry as stocks within the same industry tend to move up and down to a similar degree (i.e., in other words, stocks in the same industry tend to be correlated to each other). This will help us to build a stock portfolio that becomes more stable.
2. What level of math is needed in order to understand the entirety of finance and investing?
If I can define the question in terms of “what knowledge one needs to be successful with investing,” the answer depends on the type of investing one is considering.
For example, if one is going to stick with large-cap market exchange traded funds, like the iShares S&P 500 ETF (IVV), one really doesn’t need a high level of math. An alternative to making a big lump sum purchase is when you establish an equity target between cash and the stock ETF, and you stick to that target over time.
If the stock market goes down, by sticking to the target, you are guided to top up equities to your target. Similarly, if the stock market goes up, you are guided to trim equities to bring your portfolio back down to your target. So in summary, by sticking to your target, you are buying stocks when they go down and selling when they go up. This technique helps you to make rational buying and selling decisions with the potential result of better risk-adjusted returns.
One will need to be mindful of commissions as well as managing foreign exchange costs. For small additions to equities each month, to manage commissions, you might choose a no-load diversified large-cap U.S. stock fund with a low MER that attempts to mimic the returns of the Standard & Poor’s 500 Index.
You might also allow some level of fluctuation so you are not trading all the time and find your profits go toward commissions. For example, if your equity target is 75%, then you might not rebalance and buy until equities drop to 70% of your portfolio value or you might not sell until equities rise to 80%.
If you are going to move beyond indexes to individual stocks, there is an opportunity for you to avoid the expensive stocks and the crappy businesses within the stock market index. And you can possibly generate even better risk-adjusted returns through equal weighting your stocks as opposed to market-cap weighting which normally occurs in market indexes.
As soon as you stray away from buying stock market indexes, you have to be mindful as to how to control non-systematic (e.g., company and industry) risk, and you need to be disciplined as to how you buy and sell stocks. For example, you should use a strategy to help you select stocks where there is a direct cause and effect relationship between the strategy variables and a stock’s price, and the stock variables you are using to select stocks should be statistically significant. This will help you to make more rational selections as opposed to being lured into buying sexy overpriced risky stocks.
But we’ve digressed a bit here. With selecting stocks, it is helpful to have an appreciation of statistics as well as grade 10 math (e.g., one should develop a comfort with financial ratios as to relative price attractiveness, profitability, liquidity, debt and efficiency. If you are going to attempt to try to calculate a company’s intrinsic value (which many investors don’t do), then you need to understand present value and some corporate finance to figure out a reasonable discount rate.
Your education should go well beyond that to also include business strategy and competitive advantage, economics with respect to economies of scale, industry structure and life cycles and the impact of interest rates, inflation and business cycles. You might also spend some time reading stuff on Warren Buffett and Benjamin Graham to develop an appreciation of value investing.
3. Is “value investing” (Buffett and Graham approach) a good investment strategy for long-term goals like investing for retirement?
To answer this question, one needs to have an understanding of the Buffett approach. My understanding is that Buffett seeks ownership in quality companies capable of generating earnings that are on sale, but he is not looking for just any type of company. He needs to be able to understand the business to model its cash flow and arrive at its intrinsic value. My understanding is that he limits companies for consideration to those where
- The company has performed well in terms of return on shareholder equity (ROE) (net income/shareholder’s equity) relative to other companies in the same industry, that the company has consistently done so for at least the last five to 10 years.
- The company does not carry an excessive amount of debt. For example, Buffett seeks companies with a low debt/equity ratio (total liabilities/shareholders’ equity).
- The company has high profit margins (even better if they are increasing) and should be consistently high for at least the last five years.
- The company has been public for at least 10 years. If it has not been around for at least that long, one may have less confidence in attempting to determine future cash flows or future dividends for discounting to arrive at its intrinsic value.
- The company possesses some competitive advantages as opposed to being a commodity-type business where its products are indistinguishable from those of competitors’ products. Any characteristic that is hard to replicate is what Buffett calls a company’s economic moat or competitive advantage. The wider the moat, the tougher it is for a competitor to gain market share.
- The stock is selling at a discount of at least 25% compared to its intrinsic value.
To me, these look like very reasonable criteria in which to search for businesses.
4. What should I know before I start value investing?
Here is my brief checklist.
- If you have debt, your first investment goal should be to pay it off as quickly as possible.
- Once your debt is paid off, establish an “emergency fund.”
- If not retired, you need to save every month and know the amount you are saving is enough so you can afford to retire.
- Set and stick to an equity target (a percentage of your portfolio that will be invested in common shares).
- Don’t put all your eggs in one basket.
- When you invest, seek cash flow (dividend and interest income) – otherwise you are gambling.
- For stocks, stick with large blue-chip dividend payers.
- The best opportunity for outperforming is to buy when a quality investment (that is not impaired as to its future ability to generate earnings) is substantially down.
- If you can’t do it yourself, hire someone with experience who can.
5. How should one invest in a bear market?
A bear market is when investments go on sale. It is the time to be buying. Use your equity target to give you guidance as to how much to buy. For your living needs within three years, those funds should not be invested in common stocks. You want to avoid the pressure of having to sell when investments are down which can create permanent losses.
During a bear market, you might stick with the highest quality large-cap stocks that pay a good dividend (so you are paid to wait). These types of large companies are supported by their dividend yield and tend not to drop as much. They are much less risky but are also more likely to recover when the market recovers. Smaller companies, emerging market securities, cyclical companies and commodities are much more volatile and can drop to levels that you might not think possible.
Be mindful not to put too much into any one stock so you manage company risk.
6. What are examples of sustainable competitive advantages?
Competitive advantage may exist where a business is able to provide a customer with a product at a lower cost than competitors or provide better value to the customer at a comparable cost. When a company can sustain such advantages through time, this can result in the business generating a high level of return.
One would typically examine the competitive forces that determine industry profitability including: the bargaining power of suppliers, threat of new entrants, bargaining power of buyers, threat of substitute products or services and the rivalry among existing firms.
For example, for entry barriers, we might consider economies of scale, proprietary product differences, brand identity, switching costs, capital requirements, access to distribution, absolute cost advantages, proprietary learning curve, access to necessary inputs, proprietary low-cost product design, government policy and expected retaliation.
In Canada, the banking industry operates in an oligopoly market structure with the six big banks dominating over 90% of the banking business. As such, these banks don’t have to compete as intensively and can generate excess returns through time. Their returns through time have generally been better than the S&P/TSX Composite Index.
7. What are the absolute best, most crucial tips/ideas to succeed in long-term investing?
We should seek to own a portfolio of investments that generate enough income to meet our living needs without having to rely on those investments going up in price.
8. What are the essentials of due diligence when investing?
- To know your clients – including their personal and family backgrounds, financial situations, financial goals, cash needs through time, liquidity requirements, investment experiences and risk tolerances.
- To know your product – to understand the investment, to make sure that investments are suitable, that the percentage of investment is reasonable and that risk is controlled.
9. What kind of stocks would you rather avoid holding because they are riskier than others?
As most of my clients are retired or near retirement, capital preservation and the development of stable dependable cash flow from their portfolios to meet their needs are typically key objectives.
For common stocks, I focus on high quality income-generating businesses that:
- Produce goods and services needed for our economy in good or bad times (like banking, insurance, pipelines, energy, electricity, telephone and television [telecom], food, etc.).
- Are dominant where they operate.
- Are profitable.
- Don’t employ an excessive level of debt.
- Produce a good dividend yield where the company income is more than sufficient to cover the dividends.
Stocks that don’t possess these attributes are those I tend to avoid. These include:
- Small-cap companies.
- High growth companies with high price-earnings (P/E) multiples.
- Stocks that don’t pay dividends.
- Stocks with very high levels of debt.
- Poor businesses.
10. What are some investment lessons you learned in 2016?
In 2016, I had no exposure to materials and very little exposure to energy which were industry sectors that performed extremely well. Generally these sectors tend to be more volatile than the market, don’t typically pay decent dividend yields, and their earnings tend to be cyclical and vary from one year to the next.
I learned that in sticking with my investment philosophy, it means there could be times when I could underperform. But straying can mean introducing added risk to clients which my experience has found over the years not to be worth it. Fortunately though in 2016, there were other industry sectors, like the financials, that performed very well so that we were still able to generate good returns.
11. What discount rate do you use in your valuation?
I rely on relative valuations in screening to find stocks of interest. I’ll then look at research reports as to their indicated intrinsic value (which might be called price target or fair value) as opposed to trying to calculate them myself. Ideally I would like the stocks for consideration to have a market price with a good discount to its intrinsic value. The amount of discount can vary – like today it is tough to find good businesses selling at significant discount.
12. Which is more useful, earnings yield or P/E ratio? Why?
Earnings yield (earnings per share divided by stock’s market price) is basically the inverse of the P/E ratio. The P/E ratio equals stock market price divided by earnings per share. So they are equally useful.
13. With just public information, how can you be confident that your valuation is correct while the market is wrong?
Your thesis in investing in a stock may be correct, but because of the human behavior of others, your identified stock price can remain under its fair value for years. There is no certainty when it comes to investing. For this reason we must buy enough stocks under a strategy in order to get the strategy returns.
14. What are the key attributes of a great investor?
A great investor is someone who
- Has spent a lifetime building up educational and professional investing credentials.
- Has gone through a period of articling or training with a seasoned financial adviser.
- Has been investing for more than 10 years.
- Uses one or more stock strategies to identify stocks for selection.
- Understands your needs of cash from your portfolio through time.
- Pays great attention to risk management.
- You trust implicitly.
- Provides advice that is always in your best interest.
15. What are the best books on investing?
Read “The Richest Man in Babylon” by George S. Classon.
16. What skills are needed to succeed in distressed debt/special situations investing?
By definition, distressed securities are experiencing financial or operational distress, default or are under bankruptcy. There is a very real possibility that any investment could result in a loss of most or all of your investment. For these reasons, I would likely not invest in this type of investment as it does not exhibit the risk and return profile I seek that would be suited to my clients.
The skills to succeed come down to spending enough time to really understand this type of product. But given the time commitment required, you might better use it toward investigating other types of investments.
17. What are the best books about special situations investing?
As I don’t have much interest in this high risk area as these investments likely aren’t suitable for my clients, I don’t know offhand any books on special situation investing to recommend.
18. What are the best web sites to follow for value investing-oriented investment ideas?
Morningstar, Value Line and Zacks might be good places where they write about stocks as well as provide you with resources to help you in stock selection.
19. Who are the best value investors in the U.S. with under $1 billion in capital?
I don’t typically use third-party managers. You might look at a Credit Suisse article called “On Streaks, Perception, Probability and Skill.” It discusses identifying skilled managers versus those that are just lucky.
You might also read an article by Ernst Gronblom called “Choosing Money Managers.”
20. What are the best mutual funds for value investors?
I don’t sell mutual funds. Mutual funds tend to be more expensive and more appropriate for retail investors.
With more money to invest – at least $100,000 to get in the door, but most will want at least $500,000 – you can hire a portfolio manager at a competitive cost who can help you through
- Generating higher returns and/or lower risk by selecting the right asset mix, selecting good investments, sheltering income from taxation, controlling risk and setting aside funds for anticipated needs (so you are not forced to have to sell investments when they are down). An experienced investment professional may also help you avoid making costly emotional or irrational investment decisions.
- Eliminating, reducing and deferring income taxes so you’ll have more money growing faster to meet your goals.
- Protecting your family against devastating financial losses – like the death, disability or illness of the family breadwinner, property loss, theft or damage, and liability claims. Without such protection, your lifetime of savings could get wiped out.
- Design an effective estate plan so your estate will be distributed according to your wishes, minimize tax and transfer costs, and protect your legacy from a variety of creditors. This not only gives you peace of mind but hopefully will ensure your life savings is there to take care of your loved ones throughout their lifetime.
21. For an individual relatively unsophisticated nonprofessional investor, what are the most undervalued asset classes today and what are the best funds or mechanisms to invest in them with a buy-and-hold mentality?
An unsophisticated nonprofessional investor should not buy individual stocks but rather stick with large-cap stock market index investments through either exchange traded funds or mutual funds formats. They should also not put all their money in the stock market. Take a look at iShares S&P 500 ETF with an MER of 0.04%.