This was my first article published at RealMoney, in October 2003, I think on the 17th.

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As investors go, I am a ?singles hitter.?? I don?t get many investments where I more than double my money.? But I bat a high average when I invest.? One of the keys to this is insisting that the companies that I invest in possess ?financial slack.?? Financial slack means that a company can make a few mistakes, and not get killed.? This is the equivalent of Ben Graham?s margin of safety.

If you run a portfolio with a small number of stocks, it is important to avoid companies that destroy your capital.? It is difficult to recover when your capital has been impaired.? A good defense allows the offense to play aggressively, without losing sleep at night.

The market is a cyclical beast, with cycles inside cycles.? The market has a cycle of its own, but industries have their cycles within the cycle of the market.? This is where I find my advantage in the market ? analyzing industry cycles.? Industries go in and out of favor.? The time to buy a company in any industry is when it is out of favor; as a matter of risk control (and humility) the companies to buy when an industry is out of favor are those with financial slack.? If you are wrong about the industry, you won?t lose much; if you are right, the gains will be significant.

My example for today is the steel industry.? The steel industry is economically necessary for our world, but is in decline in the US.? The older integrated steel mills are inefficient compared to the mini-mills, and foreign competition.? The foreign firms have varying advantages ? cheaper labor, and governmental subsidies, both implicit and explicit.

Understanding Cyclicals

Steel is a cyclical business that follows the pricing of steel.? This may sound obvious, but the finance textbooks teach us to look at companies in a mode that assumes constant earnings growth.? This is a rare condition in the real world, and non-existent with cyclical companies.? With a cyclical company, watching the pricing trends of the commodity produced is the most critical factor in short-run stock performance.? Longer-term, it comes down to:

1. Buying industry leaders with impeccable balance sheets.
2. Reasonable operating leverage ? they should be profitable at the cycle trough
3. Buying them when the industry is hated.? Buy them cheap.
4. Only buy firms that use free cash flow at cycle peak in a way that prepares for the trough.

Point 1 comes down to size and financial leverage.? Points 2 and 4 suggest a corporate humility that arises from restraining the increase of productive capacity when times are good, and a willingness to invest when times are bad.

Point 3 is the hardest point.? In growth industries, P/E ratios are a reasonable measure for valuation.? In cyclical industries, P/B [price-to-book] and P/S [price-to-sales] ratios are more reasonable, because earnings are less stable and reliable.? With cyclical companies, P/E ratios are typically lowest at the cycle peak, when companies have peak earnings, and high-to-nonexistent P/E ratios at the cycle trough.

Other issues around steel

There are a number of structural problems around the steel industry.? Tariffs to protect US production prevent inefficient capacity from exiting the industry.? The hint of removal or increase of tariffs can move steel stocks markedly.? Second, labor unions have not figured out how deeply uncompetitive the US steel industry is.? Between total compensation costs and work rules, the unions help make many US steel uncompetitive.? Finally, pension liabilities are often large relative to the total capitalization of many steel companies.? It is no surprise that one of the key issues regarding emergence from bankruptcy in the steel industry involves reduction of pension benefits.

Conservative investors investing in the steel industry will look for companies that do not have large pension deficits, and companies that are non-union, or where the unions have made peace with management.? They will also look for companies that can exist without tariff protection.? (Perhaps politicians will realize one day that more jobs hinge on the use of steel, rather than its production, and eliminate tariffs because it preserves more jobs, but I doubt it.)

Companies

In my investing, in the past, I have made money on AK Steel [AKS], Algoma Steel (insolvent), and Nucor [NUE].? When steel prices were higher, low cost producers (at that time) like AK and Algoma did well.? Their main problem was their debt loads; a company that is operationally efficient still has to service its debts.? EBITDA is all very good if you are a bondholder, but stockholders need free cash flow ? AK and Algoma had none of that as steel prices fell.

In this uncertain environment, I am invested in Nucor.? With little debt, a non-union workforce, and relatively low cost production, Nucor is an acceptable stock for conservative investors.? Nucor has been a consolidator of steel assets on the cheap amid the many bankruptcies that have plagued the sector.? When steel industry conditions normalize, they will earn a good return.? It has a strong focus on return on equity.? It should earn a about $1/share in the trough, and perhaps as much as $5/share at the peak.

But is it the right time to own Nucor?? Is it cheap enough?? I made my last purchase in the high 30s, and would purchase more there.? In the high 40s, I am a little more indifferent, because I would sell Nucor in the low 60s.? Given the normal level of profitability for Nucor, I view it as a buy below 1.3x book, and a sell at over 2x book.

An alternative

I do not have a position in POSCO [PKX], but am considering it for my portfolio at present.? POSCO, formerly Pohang Iron and Steel, is the third largest steel producer in the world.? It is based in South Korea, and is presently the lowest cost producer in the world.? Debt is low, and if you can trust Korean GAAP, it has earned consistent money for nine out of the last ten years.? It trades around its book value, and 7x 2004 earnings ? very cheap, unless we get a new war on the Korean peninsula.

As with any investment, the risks must be weighed against the likely returns.? I have one Korean company in my portfolio.? Do I want to double my risk?? That is my main question on POSCO.? Absent that, I would rate it a buy for those who can tolerate the risks involved.

The following was published at RealMoney, but I don’t know the date.

?I can always find good stocks to buy, but figuring out when to sell is harder.?? (My Mom, when I was much younger.)

In some ways, my career in investing has been a happy accident.? Much of my career has been in the insurance industry, working as an actuary.? Being a generalist, with a focus on investments, this helped me to learn a great deal about institutional investing, before doing it myself.

At Provident Mutual, now a part of Nationwide Financial Services [NFS], I was the one financial analyst on a committee that chose the managers for a series of multiple manager funds for our pension clients.? I ended up interviewing 30-40 top money managers over a three-year period.? The similarities and differences were interesting.? Two areas that we would always ask about would be their buy and sell disciplines.

On buy disciplines, the answers varied considerably.? But sell disciplines were usually pretty similar, falling into three groups:

• Price target met
• Failure of momentum
• Fundamentals deteriorate

The last of these is squishy, and I would usually ask, ?How can you detect fundamentals deteriorating ahead of everyone else??? This would usually elicit the intelligent equivalent of a mumble.

There were a few of the better managers who used what I later called ?The Economic Sell Rule.?? The economic sell rule says that if a manager finds an asset that he likes better than one that he presently holds, he should swap.? That means the manager either intuitively knows what he likes better, or estimates the anticipated rate of return (adjusted for risk tolerance) over the time horizon that he manages, to appraise the desirability of new assets.

I ended up calling it the economic sell rule, because each of three rules listed above had problems of their own.? In a market where valuations are crazy, like the late 90s, many price targets get hit.? If the manager is a ?long only? manager, and has to stay fully invested, he can begin to run out of ideas on where to put money to work.? For managers that can go both long and short, there is the problem that as price targets get hit on the long and short side in a sustained market rally, the portfolio gets shorter and shorter.? And in a sustained decline, the portfolio gets longer and longer.

This is an implicit bet on mean-reversion, which no doubt happens, but often not soon enough for the clients of the manager, who can lose assets under management as underperformance persists.

Failure of momentum could take two forms: valuation-driven managers with price declines below original cost, and momentum-driven managers that would sell when relative strength weakened.? Some valuation-driven managers would often sell any stock that declined more than a threshold percentage, whereas others would do a review at such times to check their investment thesis.? After all, if a manager liked the company before, certainly he should like to buy it cheaper, no?? Unfortunately, the pressure for instant results, measured on a monthly or quarterly basis, can force decisions that are less than fully rational.

As one manager said to me, ?If it goes down more than 20% from where we bought it, we obviously didn?t get the story right, so we sell it and move on.?? This is a recipe for turnover and underperformance.? It is normal for stocks that are good long run performers to have 20% drawdowns once a year or so.? Even with good research analysts, the odds of a 20% drawdown are decent, even immediately after a recommendation.? In my own portfolio, after reviewing my thesis, I view 20% drops as buying opportunities.

Because I don?t manage money that way, I can?t comment as competently on the momentum-driven managers.? I will only note that they have high turnover rates, and that their trading tends to demand liquidity, rather than supply it.? In future articles, I will comment on the tendency for those who supply liquidity to be rewarded for it.

Though I never heard a good explanation for having a competitive edge in detecting deteriorating fundamentals, following the fundamentals is the most useful way for developing a sell discipline.? Absent surprises, companies and industries perform better or worse as investors change their estimates.? As the forward-looking estimate of future returns for a company falls below that of prospective purchase candidates, it is time to swap out.? As the forward-looking estimate of future returns for a company rises compared to other companies in a manager?s portfolio, it is time to buy more.

Consider when a ?surprise? happens to a company.? Surprises can be positive (e.g., possible takeover, good earnings), or negative (e.g., bad earnings).? After a surprise, is it time to sell, buy more, or wait?? It boils down to how much the surprise affects the manager?s estimate of value for the stock.? (And to some degree, how much it has affected the estimates of others.)? How much has the long-run earning power been affected?? For how much could the company be sold off?

Answering questions like these will lead to the estimates of value that can properly inform sell decisions in volatile times.? Using a discipline like this forces a manager to re-estimate a forward-looking estimate of return, rather than let greed or regret drive decision-making.

In my next article, I will show how this process has worked in practice for me, together with another technique that some managers use to pick up some incremental return, and reduce risk.