The Biggest Investing Lesson I Ever Learned

By Andrés Cardenal - September 13, 2012 | Tickers: AMZN, AAPL, COH, GOOG | 0 Comments

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There are many different opinions about what makes a good investment strategy, but if I had to choose one important factor which is a big determinant of success under different investing methods, it would be to follow your own independent thought and invest accordingly.

Try to isolate yourself as much as possible from outside noise, focus on the cold hard evidence and your own ideas as opposed to other people´s opinions. Learning to analyze stocks is not the hardest part of the investing process; following your convictions is. Understanding the concept is not so hard, but applying it in the real world can be a different thing, especially in complicated scenarios.

We all remember those dismal times during the global financial crisis, when many renowned economists were claiming that the world economy had changed forever, and the US consumer would never truly recover from the recession. Those were really frightening times, but full of opportunities as well.

As for me, I like buying high quality companies at reasonable valuations. I like strong competitive advantages, solid profitably and a fair price tag attached to the stock.

Back in 2008, I became familiar with Coach (NYSE: COH). I´m no expert in the fashion industry and particularly not in handbags and accessories, but the numbers were very clear. I could see that Coach was reporting surprisingly resilient sales and profitability figures during those times, especially in comparison to other companies in its industry, which were having a much tougher time.

As you can see from the chart, sales remained fairly stable at Coach during the great recession; although earnings per share suffered a bit due to falling profit margins – explained by price markdowns during the crisis – the company was still doing quite well overall.

Selling luxury products in a deep recession can be a very hard business, but Coach was holding its sales levels really well in exchange for some very moderate margin adjustments. You need a really strong brand, combined with knowledgeable management to go through this kind of scenarios in such a good shape.

However, the company sells high end discretionary items, and most of the “experts” were saying that kind of businesses should be avoided like the plague. Investors were selling shares of Coach like there was no tomorrow, so the price fall became clearly exaggerated in regards to the slowdown in earnings. This brought the Price to Earnings ratio to record lows below 10, a particularly cheap valuation considering it was based on transitorily depressed earnings.

At the end, the opportunity was just too big to ignore, so I decided to jump in. In hindsight, it was a great decision, and I learned a lot about independence of thought from that experience. Had I not been able to ignore all the outside noise, I would have missed a fantastic opportunity.

Fast forward a few years, and Coach is still the great company it was back them, it has gross margins above 73% and operating profitability over 30% of sales. These numbers are well above industry averages, and a good reminder about how rewarding a powerful brand can be for shareholders. Coach is expanding aggressively into China and other Asian markets, where its products are well received, this should fuel some exciting growth opportunities in the middle term.

 Valuation wise, the stock is not as screamingly cheap as during the crisis, but the numbers are still very reasonable. Coach is trading at a P/E ratio of 17 times earnings during the last year and 13 times earnings based on next year’s estimate. The figures are attractive in comparison to an average P/E of 19 for the industry, especially considering that Coach is one above overage company in terms of fundamental strength. As it turns out, the stock is still a great company at a fair price, so I´m holding my Coach shares.

Something similar happened to me with tech companies during the crisis. Having learned from the teachings of value investors like Warren Buffett and Ben Graham, I was naturally reluctant to invest in the tech industry. But companies like Apple (NASDAQ: AAPL) and Google (NASDAQ: GOOG) were going through the crisis in an outstandingly good shape, so I decided it was time to take a deeper look at their fundamentals.

Apple was offering a very interesting case study back them, sales of iPhones were booming, and the company was reporting raising sales, increased gross profit and growing earnings per share, all while selling expensive electronics during one of the worse recessions in history.

Google wasn’t growing as fast as Apple during those years, and it even suffered a drop in earnings per share due to increased spending in 2009. But sales were still increasing, and so were gross profits, a remarkable performance for a business operating in such a cyclical industry as advertising.

Buffett wouldn´t touch those companies, he believes the tech sector is just too dynamic and subject to change, as the big winner of today can easily be the loser of tomorrow. As for me, I learned a lot about the sector through the years, but I can hardly call myself an expert in that industry.

Fortunately, that´s not a prerequisite to identify a wide economic moat, the term Buffett uses for competitive advantages. Apple and Google are two tremendously powerful brands, and as a daily user of their products I can still understand how they make my life better by providing superior products to those offered by the competition.

I´m still holding my Apple shares, actually it’s the biggest position in my portfolio, and I have no plans to sell this innovative leader anytime soon.  The company has expanded into new products like the iPad with remarkable success, and it has solidified its position as the most productive retailer in the US in terms of sales per square foot and store profitability.

And the growth story is far from over; new products like a smaller iPad and the much expected Apple TV could be important in the middle term, while digital products and apps have some considerable long term potential. Also, China and other emerging markets still have a much lower penetration rate than the US.

All of this comes at a really attractive valuation. Apple carries a P/E ratio below 16, and the forward figure looks quite cheap at less than 13 times estimates. This is below the average P/E of 20 in the tech business, and Apple is by no means an average tech company.  Both from a fundamental and valuation perspective, I’m very happy with Apple being my biggest position.

Google presents some uncertainties in the middle term, as the Motorola Mobile integration will probably have a negative effect on profit margins. The transition towards mobile computing could be another source of additional expenses, and it will require time and effort to adapt. But Google is still the undisputed leader in online advertising, and the company is strongly positioned for the mobile revolution with its enormously successful Android operating system

The online search giant is trading at a P/E of 20.5 - 14 on a forward basis – which still allows for upside potential from a valuation point of view. Looking beyond the middle term uncertainties, Google still looks like a great company at a reasonable price.

Technological advantages, patents and a differentiated brand are three important sources of competitive advantages for these companies. Just because Buffett doesn´t like investing in the tech sector doesn´t mean I should stay away from it too. You see, I´m not Buffett – though I would certainly be willing to trade bank accounts – and staying true to myself sometimes mean going against one of the greatest investors of all times.

Just like I had to ignore the apocalyptic forecasts from the media in order to buy Coach, I had to make a much tougher decision and forget about Buffet´s philosophy to buy Apple and Google. I do believe the Oracle of Omaha will come to forgive me in due time, provided I teach him a few things about my fabulous investment career.

Leaving jokes aside, none of this is going to guarantee a 100% success rate, and I´m still trying to figure out the Amazon (NASDAQ: AMZN) case. I think it’s one of the most successful and disruptive companies of our times, but it has always seemed too expensive to me.

Even worse, the company has been expanding sales at the expense of profitability over the last years, investing heavily to deliver more products and better services at aggressively low prices. Earnings per share have been collapsing as Amazon puts its efforts, and shareholder´s capital, to work in order to increase sales, not earnings.

A falling profitability combined with a sky high valuation ratio is not the kind of company I would consider for a purchase, but this has clearly not been my most profitable decision. Amazon is making new historical highs while carrying a scandalously high P/E ratio above 300 and defying the nonbelievers.

What to do about those cases in which the market proves you wrong? Absolutely nothing. I know my investment strategy is not perfect, and I will sometimes miss some opportunities in high growth companies trading at high valuations for many years, but that´s OK.

Some flexibility is always healthy, but I don´t like going too far away from the boundaries of my own strategy. I need to be sure about the merits of my investments, because that´s what provides the confidence to stick to my convictions when things get shaky

Long term investing is about reasonable analysis and character strength. You can learn to analyze stocks from books and other resources, but independent thinking - and action - is a much harder, and perhaps more important, ability to implement.

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