Newsletter February 18, 2013

InvestorsFriend Inc. Newsletter February 18, 2013

Stock Traders are (Vastly) Different Than Stock Investors

Stock traders, in their purest form, focus only on share prices. A “technical” analyst looks at the chart of the stock price and tries to discern where the stock price is headed. He basically tries to follow the smart money. He does not look at the fundamentals of the company because he believes that all that information is already embedded in the stock price. A stock trader will often use stop losses and will be inclined to sell if a stock price drops. A pure technical analyst has every reason to sell in a panic if the share price drops. He or she has no basis to know if the stock price will recover. A pure technical analyst has not even glanced at the actual earnings of the company underneath that stock ticker. Stock traders or technical analysts by definition trade often and trade swiftly with little time for analysis.

Stock investors, in their purest form, consider that they own tiny shares of actual corporations. They look to own shares of companies that are likely to make increased profits ver the long term. And they look to buy those shares at attractive prices. They are happy to own the shares for a long time if the earnings of the company keep growing. They aim to sell if the stock price gets too high in relation to the true value of the company. A fundamental analyst believes that he can look at the value of individual companies and find some companies that are trading below their real value. A (fundamental) stock investor is inclined to buy more shares if the price declines unless there has been some change in fundamental facts to account for the price drop. A fundamental stock trader is ultimately trying to be the smart money rather than follow the smart money. A fundamental investor who believes that a stock price is undervalued and has good reason to think so is in a good position to be calm about a drop in the market price. He or she may have good reason to be calm and to have confidence that the share price will recover as the earnings of the company grow. Fundamental stock investors by definition trade infrequently and buy and sell only after thoughtful analysis. They inherently move slower than stock traders who follow “technical” or charting techniques.

Most retail investors are somewhere between the two extremes. Whether they do their own analysis or follow other analysts they understand that fundamentals matter a lot but they worry a lot that if a stock price declines it might keep going down. Different investors are at different places along the spectrum from day trader to long-term value investor. And individual investors move along this spectrum as their mood changes. Fear can make a a value investor panic and sell like a day trader. And greed can turn a value investor into a one who chases a stock up a price chart.

InvestorsFriend.com is a service that is uses strictly fundamental analysis. Charting techniques do not suit our intellectual interest or emotional makeup.

Here is a little analogy I have to illustrate the difference between a fundamental stock investor and a technicals based stock trader. Imagine  the two of them in action getting their cloths washed. Let’s imagine that before this day they have never witnessed a washing machine or cloths dryer in action. (Mom always did the laundry).

The fundamental stock trader studies the machines before approaching with his cloths. He has read how the machines work. He knows that his soiled but dry pile of cloths will need to get wet and twisted up before they will eventually emerge fluffy and warm and dry. He puts the cloths in the washer and then watches calmly as the cloths get all wet. He later puts them in the dryer and ultimately collects the clean cloths.

The technical based stock trader walks in never having seen a washing machine in his life. (He cares nothing about fundamentals and how washers and dryers actually work). He puts in his cloths. A few minutes later he notices that his cloths are now “under water”. In a panic, he pulls the cloths out and leaves. He had no basis to understand that the cloths first needed to get wet before later emerging dry and clean and fluffy.

Okay, that is a total exaggeration of the situation, but hopefully illustrates the point.

Fundamental Investors Need to Understand Economics

A good fundamental investors should strive to learn something about both micro economics (how individual companies make money) and about macro economics (how the economy works).

It’s probably more important to understand how individual companies make money and to identify some bargains than it is to understand the macro economy. In fact, I am not sure anyone truly understands the macro economy and things like the implications of and limits to national debts and money creation.

We’ll start with some macro economics.

The Magic of Our Economic System

Writing in 1776, Adam Smith wrote about “the division of labour” and said that it was the greatest contributor to the the increase in human labor productivity.

Adam Smith noted that in a factory setting, using the division of labour, 10 men were making 4800 pins per day each when he doubted that each, working without the machinery of the factory, could  make one and certainly not more than twenty per day working on their own.

Ponder for a moment the complex manufactured goods we are all able to buy. Most employed adults in the developed world today can afford to buy, a car, a refrigerator, a large flat screen television, a computer, light bulbs, an electric stove, a vacuum cleaner, a toaster, a coffee maker, furniture, cloths, and more (and certainly a boatload of pins if wanted).

Not all that many years ago almost everyone on earth toiled very hard just to survive. Only a hundred years ago in Western Canada, home steaders worked very hard indeed to eke out a living that did not include electricity or indoor plumbing.

Today, our economic system allows most of us to trade about 40 hours per week for enough money or compensation to provide for the bare necessities of life (food, clothing and shelter) along with quite a bit of goods, services, entertainment and general comfort over and above the bare necessity.

Admittedly, our economic system is far from perfect. Some people certainly garner an outsized share of “the spoils”. Others get too small a share of “the spoils” for their efforts.  Some people are highly educated and willing to work but can’t find suitable employment. But overall, our economic system is really a wonder to behold. When we feel deprived, it usually more that we are deprived in relation to others rather than literally deprived (few go without adequate food, clothing and shelter).

Recently I saw a full size refrigerator on sale for $500. In Canada a wage of $25 per hour would probably be considered pretty normal. (Higher than average but certainly not abnormally high). Is it not a marvel that a fairly typical person can exchange just 20 hours of their time for something as complex and useful and large as a refrigerator? Even after taxes most people can earn a refrigerator in about four days. Even at minimum wage it would not take more than two weeks effort to earn a refrigerator.

Can you imagine the hours it would take for even a very skilled tradesman, with a well equipped shop, to build his own refrigerator? I would hazard a guess that just to buy the components would cost FAR more than $500. And to try to do it from basic materials would be almost impossible. And if someone could build a refrigerator from raw materials can you imagine how ugly it would be? Think about the wonders of our system of factories and division of labour that can build a fridge and ship it to a store near you such that most of us need exchange only about four days labour to buy it?

And yes, perhaps it was built in China. To me, that makes it all the more amazing and wherever it was built we can still buy it in exchange for a quite small amount of our time.

The Magic of Our Organized Systems.

It is our organized market system that creates our overall high standard of living. Several key things are needed for a well functioning economy. These include law and order, property rights, education, incentives to work, a relatively free market exchange system, a monetary exchange system, banking and probably some others that I am not thinking of.

Think about all the aspects that come together for a factory to make refrigerators. Other factories need to exist to supply components such as the compressor and motor, the tubing, the plastic, the metal, the insulation and other components. Electricity needs to be generated and delivered to both the factory and the customer’s house. The factory had to be built in the first place and equipped with production machinery. That involved someone making a long term investment. It may have involved money borrowed from a bank and likely involved (somewhere along the way) investors buying shares in a company. The factory will have a production line and a division of labor. Refrigerators are ultimately shipped to retailers. The retailers reliably pay the factory. There are entire systems set up to insure that factories can ship refrigerators to retailers without much worry of not getting paid. There are computer systems in place that make it easy for the retailers to order refrigerators and for the factory to manage its inventories of finished products and components.

Once everything is set up and in operation dozens and dozens of systems interact in such a way that the refrigerator production is almost automatic. It becomes easy for everyone involved. And it manages to produce refrigerators that people can buy in exchange for not very many hours of their labor at all.

Systems are everywhere. Very few of us work outside of the system of division of labour. Most office workers would turn around and head home if the computers were down for a day. We may not feel like we are part of an assembly line. But invariably we are. We all depend on numerous systems and numerous others to get our jobs done. (Well except for that one in a million guy who went totally off the grid and ekes out a living off the land while living in a hovel someplace.)

Who Deserves the Credit for Manufactured Goods?

Factory workers may like to claim credit as being the true producers of goods like refrigerators. And they do deserve some credit. And certainly the owners of the factory deserve some credit for supplying the factory and the machinery. And the office workers in the factory that order the components and work the computers and run the payroll and hire the shop workers are also needed. In fact it is the entire inter-related economic and government system as a whole that makes it possible to manufacture goods in a factory.

Factories could not run without electricity and water. They could not run in a lawless society. They would not exist without the various inventions and technologies that they use. They would be pretty useless without roads and delivery trucks and retailers. It’s all interconnected.

No individual worker or manager or owner is essential to the process. The harsh reality is that we are all quite replaceable.

Most of the credit for the ability of factories to produce refrigerators must go to the collective market and governmental system. No individual deserves much individual credit and yet we all contribute to it collectively.

To me it is a sort of magic for which we should be grateful.

Is Leadership as Important as Systems?

Recently I read an editorial that claimed that what we actually need are a lot less leaders and bosses. That bosses and leaders just mostly get in the way.

The editorial (by Bill Bonner) said:


The point is, the world needs a lot fewer leaders than it has. Most of the time, people go about their business with no need for the expense and distraction of leadership. That is true in businesses as well as government. A leader just gets in the way, wasting everyone’s time and energy.

That is a good point. Think about some of the most successful businesses around.

Walmart obviously benefited greatly from the leadership of Sam Walton. Sam started with one store. Had he been a typical leader he would have been too busy micro managing everyone to have ever found time to expand beyond one or at most a few stores. It must have taken a focus on systems to allow the huge expansion. Sam Walton first developed a successful formula for operating and managing one store. But his real genius must have been in the ability to implement systems that would cause his formula to be reliably replicated in dozens and then hundreds and ultimately thousands of stores.

In Canada we have Alimentation Couche-Tard which has grown in 35 years from a handful of stores in Canada to now about 10,000 most of which are in the United States and a good
number in Europe. The main founder is now a billionaire. It has developed a decentralised business model that allows it to acquire many stores per year and fold them smoothly into its network. Whenever I personally think about running a store I cringe at the idea of having to hire and fire people and make sure they show up for work and treat the customers properly and not take the product or allow their friends to help themselves. There would be so many details to take care of just to run one convenience store properly. It would be exhausting. Couche-Tard obviously has developed systems that allow it to grow rapidly and yet also insure a consistent service and consistent profitability. This cannot be accomplished by micro management. It has got to be done systematically. The founding owner is still CEO but clearly there would be many stores that he has never visited. Yet they operate as he intends.

If you are a leader do you spend your days putting out fires and making endless little decisions? How about following up on your employees? If so, you are probably like most leaders. But highly effective leaders simply don’t act that way. Real leadership does not come from micromanagement. It comes from putting in a system that reliably produces the desired result.

A cloths washer is a system. It runs a cycle and produces a desired result. No leadership required.

How does a busy restaurant manage to custom make meals for hundreds of people in a few hours and manage to serve the meals relatively rapidly? It cannot be by managers running around telling people what to do. It has to result from systems whereby people are trained for certain parts of the job and they do it. There has to be a high degree of systemization at work. Yet there also has to be a certain degree of autonomy. In an efficient restaurant, a waiter does not have to ask permission about how to deal with a diner’s complaint. He is empowered to make a decision. Yet he operates within a system. I imagine that running a busy restaurant must be difficult. But having reliable and repeatable systems in place must make the job far easier. A restaurant chain with fantastic systems to follow can probably be ran by mediocre managers. Trying to run a single restaurant with no established systems in place would probably require a highly effective and energetic leader. (One who would be wise to develop some procedures and systems if she did not want to spend her life busily putting out fires.)

Leadership is fine but real leadership requires implementing systems. Real leadership is the kind of leadership that makes the putting-out-fires kind of leadership unnecessary. A business that wants to grow to multiple locations will have a very hard time doing that if it tries to rely on micro managing and putting out fires.

What’s this got to with Investing?

As an investor, I am always impressed by businesses that “are on their game”. Certain businesses just seem to get the job done reliably and without appearing to really break a sweat. Think about the likes of Costco. All it has to do is open a new store and people flock to it. It’s systems clearly work smoothly. As you go about your daily life you should be able to see which businesses are running smoothly and appear profitable. Those kind of business will not always be a good investment (the stock price might be too high). But the opposite kind of business with inconsistent service from one location to the next or harried looking and grumpy employees (who are probably micro managed) will very seldom be a good investment.

END

Shawn Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend Inc.

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