Advice to a Friend

Dear Mr. Merkel,

I was sorry to read about the demise of your firm a month ago.  I hope God prospers you in whatever path you pursue now.  I’m writing to you with a few investing questions because I know you actually can evaluate what I’ve done- and from a perspective that I think matches mine (buy dividend-paying value for the long-term), and I really would like to deliberately practice improving my evaluation of companies with testing & feedback.  If, however, my request falls under your own business plan- I understand completely.

4 years ago, I picked several energy stocks using only one metric: P/E ratio.  Since then, I found Graham’s writing on investing and your blog and started thinking that one-stick-measuring for something as complicated as a business is a dangerous game.  Using what’s available to me on Vanguard’s website (plus what I’ve learned from you and Graham), I have a slightly less incomplete model to measure a business.

I know you’re very busy, but if you ever have a chance, would you look at my scoring system and give me some small feedback?  I’m curious about a few specific things:

a) Have I left out any key aspects or ratios?  If so, what?  (and what should they be?)

b) Graham suggests going back years and years when looking at a business.  What is the point where you get such diminished returns that’s it not worth the effort to dig up the numbers?  3 years? 5 years? 10 years?

c) Follow up to b: does your answer to that question change based on the aspect examined?  (ie: EPS should be reviewed for the last 5 years but Cash only for the previous year)

d) In my scoring system, have I over- or under-weighted any of the categories?  Have I not been stringent enough in awarding points?

Naturally, I have many more questions.  But I’ll greatly appreciate any feedback you give me on these.

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I get a lot of e-mail.  I wish I could freeze time, and respond to all of it.  I have been spending time recently clearing out the e-mail box.  I am down to seven flagged messages.

The above message is from a friend of mine, whose father is a close friend of mine.  The father taught me a lot.  He might be my top intellectual influence — he is certainly in the top 5.

I sympathize with my young friend here.  I was once an individual investor myself, and I tried a wide variety of ideas before I settled on my current strategy, which grew out of my value strategy in the mid-90s, when I was much younger.

Before I answer his questions, I will say that for two decades I spent one hour per day at minimum (excluding Sundays) improving my skills.  Investing well takes training.  Simple solutions are rare.  The alternative name for this blog was “The Investment Omnivore,” because I have studied so many things in investing, from so many different angles.

Now for advice to my friend:

You have six criteria, it seems. I will handle them in the order of your spreadsheet.

1) You analyze versus 1 and 3-year price action.  With 3-year price action mean reversion is likely, but with one year price action, momentum tends to persist.  Change the direction of your scoring system on 1 year price performance, because investors tend to lag fundamental improvement in the short-run.  Momentum tends to persist over a year or two.

2) With dividends and earnings per share, your scoring is logical, though there is this difficulty — stocks react to changes in expectations, not data on the announcement date, though surprises change expectations.

3) I use the current ratio as a disqualifier.  I don’t use it for scoring, but for whether it is worthwhile to consider a given company.

4) The same is true for Cash-to-Total-Debt.  Low ratios would disqualify a company, but high ratios would not get points in my opinion.

5) And also for total debt to equity.  I should tell you that one has to consider these matters on an industry by industry basis.  Stable industries can bear more debt.

6) Then you have cheapness — price to book, earnings and cashflow.  With financials and utilities, I use P/E times P/B as a criterion, as Graham did.  With Industrials I use Price-to-Sales.  With Industrials I also look at price to cashflow and free cashflow.

So, my advice for you is this: the key idea of value investing is margin of safety.  The first task of a value investor is to assure safety.  This means using balance sheet statistics that you cut the universe in two — worthy of consideration, and out of the question.

After that, we look at valuation and analyze those companies that are acceptable to find those that offer the best values.  I give more credit to companies that have better growth prospects, but that is a soft criterion.

And after that, price momentum and mean-reversion.  Momentum works in the short run, and mean reversion in the intermediate-term.

Though you might think I am critical of your efforts here, please understand that in the mid-90s I was much like you, struggling with the concepts of value, and trying to come up with a coherent thesis.  I am impressed with your work and not dismissive.

This is a trail that I rode when I was young.  With additional study, you can do better as well.

And I say this to all readers, because there are many who follow simple ideas that fail.  I urge those who read me to read broadly in investing, and pursue the broad ideas that seem to work.