One of our favorite investing books here at The Acquirer’s Multiple is – Big Money Thinks Small, by Joel Tillinghast. Tillinghast is a protege of value investing legend Peter Lynch. In the Foreword of the book Lynch provides glowing praise for Tillinghast saying:
“I have been an active stock picker for virtually my entire life, so it pains me when critics conveniently lump everyone into the same bucket and say “active managers cannot beat their benchmarks.” Well, I am here to tell you that is simply not true. Investors need to know that not all active managers are created equal. There are many skilled investment professionals whose funds have beaten their benchmarks over time—and Joel Tillinghast is right up there with any of them. Joel has now successfully managed the Fidelity Low-Priced Stock Fund more than twice as long as I had managed Fidelity Magellan.”
“I have been investing for over fifty years and have had the pleasure of working with and meeting some of the greatest minds in investing, from Mario Gabelli and Sir John Templeton to Warren Buffett and Will Danoff. Simply put, Joel is up there with all of them. I can say this with a great deal of confidence, not only because I’ve known Joel for over thirty years but also because I hired him at Fidelity.”
While the whole book is a must read for investors, there’s one passage in particular in which Tillinghast discusses how to avoid value traps. Here is an excerpt from that book:
“Value trap” is a common epithet for stocks that disappoint or are expected to disappoint. It implies that some investing shortcut has indicated that a security is undervalued, yet it hasn’t performed well. What I dislike about the term is that it suggests that mistakes were made, but not by me. It doesn’t tell me how I screwed up, so I can avoid repeating my mistakes. Shortcuts and DCF analyses fail because of a weak link in one of the four elements of value—(1) profitability, (2) life span (3) growth, and (4) certainty. I use a brief but demanding checklist to pinpoint vulnerabilities.
1. Does the stock have a high earnings yield—that is, a low P/E?
2. Does the company do something unique that will allow it to earn super-profits on its growth opportunities? Does it have a moat?
3. Is the company built to last, or is it at risk from competition, fads, obsolescence, or excessive debt?
4. Are the company’s finances stable and predictable into the extended future, or are they cyclical, volatile, and uncertain?
In addressing each of these questions, I examine the company’s track record. I also need a forward-looking story that explains why the statistics turned out as they did and whether and how long those factors will continue. The future could be better because of new products or increasing economies of scale, or worse because of rising competition or obsolescence.
No matter how glowing the story, I wouldn’t confidently assume that a company would enjoy superior future profitability unless it had earned a return on equity (ROE) above 10 or 12 percent in nearly all of the last ten years. I pay close attention to lousy years and special charges, which often reflect adverse factors that the story might have omitted.
This checklist does not catch every undervalued stock, but it does cull out the most common sources of disappointment. It does not guarantee that bad things can’t happen, but it does improve your odds. When I can fill my portfolio with stocks with all four qualities, I see no need to consider those with defects. Most stocks will fail this screen, but that does not mean they are not undervalued. In those cases, you must work through a full DCF, watchful of the risk of forecast error stemming from the known point of vulnerability.
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