Investing Lessons from Star Trek's Ferengi
Mike is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
No race of aliens has taught us so much about finance, markets, and economics as Star Trek's Ferengi. The Ferengi Rules of Acquisition, a personal and financial code of ethics, offers a buffet of aphorisms on making money by any means necessary. Greed is the number one virtue for the Ferengi, and they use the word "ethics" only in its loosest form. But some of their rules may have some truth for investors on Earth.
The Ferengi on Stock Picking
Rule 3: Never spend more for an acquisition than you have to.
Rule 141*: Only fools pay retail.
Rules 184 & 191**: A Ferengi waits to bid until his opponents have exhausted themselves.
Stocks move up and down regularly. Wait for an eventual dip, when the price reaches the value level you're waiting for. That said, while that may work with cyclical companies, with growth stocks that dip in share price may never come. Watch for dips in the P/E ratio (or other metrics) to buy at better values, not prices, over time. There's no need to buy when the feeding frenzy is on, including right before or after earnings. If you're going to stick with a company for the long haul, you can sit back and wait for things to quiet down before making your move.
And note that Rule 141 says "fools", not "Fools."
Rule 7: Keep your ears open.
Rule 9: Opportunity plus instinct equals profit.
Rule 74: Knowledge equals profit.
Peter Lynch said that buying what you know can be the small investor's leg up on the Wall Street crowd. Find companies where you are already knowledgeable about the products or services it sells, and use that as a starting point for finding investments where you have an informational advantage. Follow the news. Learn about your companies. And stay open to reading dissenting viewpoints that contradict your investing thesis.
Rules 45 & 95: Expand or die.
A rule so nice they repeated it twice. Investors are always looking for the fastest growing companies. But growth companies that miss analysts' growth estimates can see their share price hammered.
Consider the case of Chipotle Mexican Grill (NYSE: CMG). Last October, the chain reported that sales grew less than expected in the recent quarter and management forecast slower sales growth in 2013. The next day, the share price dropped 15%. The company was still profitable and still growing, but investors sold in droves because it wasn't growing fast enough. Is Chipotle a bad company to own? No. In this case, Chipotle's shares rose back to their original price by the end of the year, and now it's even higher. (And if you were following rules 3, 141, and 191 above, you could have purchased it for a bargain last fall.) While comparable store sales are expected to show small gains next year, Chipotle expects to open 165-180 new stores, which will lead to bigger growth in the future.
Regardless of Chipotle's rebound, this rule does serve as a warning about how the market as a whole reacts to slower than expected growth. A growing company must keep expanding at a predictable rate, or Wall Street will lose interest.
The Ferengi on Financial Advice
Rule 47: Never trust a man wearing a better suit than your own.
Does your financial planner wear nicer clothes and drive a nicer car than you? That's because he profits from your money through fees and commissions regardless of how well your portfolio performs. This point was made many decades ago in Fred Schwed's book, "Where are the Customers' Yachts?" Look for on-line brokerages with low commissions and fees, no load mutual funds with low expense ratios, and if you do use a financial planner, look for one that charges a flat fee, not a percentage of your portfolio.
Rule 59: Free advice is seldom cheap.
Rule 190: Hear all, trust nothing.
Rule 218*: Always know what you're buying.
The hot stock tip that you heard at that party from your friend's former roommate's brother-in-law never turns out to be as good as you imagine. Keep your ears open for new investment ideas from a variety of sources, but don't blindly throw your money at a company without doing your own homework and research first.
Rule 44*: Never confuse wisdom with luck.
A study published last year showed that most mutual fund managers' success can be attributed to luck. Bryant University professor Jack Trifts says, “We think this occurs because ‘superior performance’ is really just random luck. Mutual fund managers who have high performance early in their careers are branded stars, while those with poor performance tend to disappear from the industry.”
But mutual fund managers are actually at a disadvantage. They don't control the inflow and outflow of money into their funds, and fickle, reactionary customers' money movements can force managers to buy and sell at the wrong times. And they must show good short term results, or else they speed up the vicious cycle of investors selling. An individual investor with the conviction to ignore the herd mentality and stick by their companies in good times and bad can beat the mutual funds in the long run.
The Ferengi on a Long-Term Investing Outlook
Rule 54*: Rate divided by time equals profit.
Rule 89*: Ask not what your profits can do for you, but what you can do for your profit
Dividend growth investing can lead to good things when you buy, hold, and reinvest your dividends. Reinvesting dividends sows the seeds for harvesting even bigger dividends down the road. Look for companies that increase their dividend annually like Coca-Cola (NYSE: KO). While its current yield is modest at around 2.8%, Coca-Cola has raised its dividend consistently every year for 50 years. With its dominant position as the ubiquitous, number one brand in the beverage industry, the company has been able to consistently increase their cash flow, allowing it to reward shareholders by consistently increasing its dividend. The reliable dividend growth, in turn, makes the company more valuable to investors looking for income, and those investors keep the share price growing at a market-beating pace, whether the economy has too much fizz or is flat.
Rule 34: War is good for business.
Rule 35: Peace is good for business.
Rule 162*: Even in the worst of times, someone turns a profit.
People spend too much time trying to guess how macroeconomic factors like war, peace, and election results will affect the stock market. Concentrate on solid companies that will thrive in any environment and leave the speculating to others.
At a time when other retailers were struggling through the recession in 2008 and 2009, Costco Wholesale (NASDAQ: COST) retained customers and made sales gains. The chain targets upper-middle class shoppers who are not hurt as much by recessions and who give Costco some amount of regular, predictable income with their annual membership fees. Those customers are attracted to the store by low prices on food and other household staples, for which demand never drops. Those values on the essentials get people in the door, where they often end up shopping for higher ticket items too. It's no coincidence that even if you're just planning to quickly pop in for a cubic yard of toilet paper, the store layout in every Costco leads you directly past televisions, electronics, and jewelry as soon as you set foot in the store.
Think about the last hundred years and of all the things that have happened in the United States: multiple wars, economic ups and downs, crises in energy, banking, and politics, the cold war, and more. Then look at what the stock market has done over the long run in that same time period. It makes a good case for long term buy and hold investing in solid companies, and leaving the worrying about the crisis of the day to others.
The Ferengi on Risk
Rule 62: The riskier the road, the greater the profit.
Rule 68*: Risk doesn't always equal reward.
Two seemingly contradictory rules. Risky stocks have a high upside. A stock can only lose 100% of its value, but it has infinite potential for gains. This means that one or two big winners can make up for a lot of smaller losers. It's good to own a handful of potential blockbuster companies, but not a whole portfolio of them.
Sometimes after you research a company, you may decide that the company is too hard to understand, the risk is too hard to quantify, and it just isn't worth the trouble. That's fine. Don't recklessly invest in high risk companies out of fear of missing "the next big thing." There's always another "next big thing" coming down the pike.
And if you do get lucky, remember not to suddenly think you're wise (see rule 44) and start making bigger bets on even riskier companies.
Rule 8*: Small print leads to large risk.
If a company is trying to obfuscate or hide things in small print, it's usually not in your best interest. Companies intentionally use tiny print, all capital letters, and tiny line spacing to make their warranties and disclaimers intentionally difficult to read and headache-inducing.
In investing, there is a similar risk in investing in complex companies with obfuscated ownership and management structures. If the explanations in the company's annual report read like the warranty book that came with your last smartphone, consider stepping away. Invest in companies that communicate with their shareholders in plain language. Peter Lynch once said that for every stock you own, you should be able to explain what that company does during a 30 second elevator ride. Sticking to that guidance will save you a lot of headaches.
The Ferengi on Socially Responsible Investing... Or Not
Rule 261*: A wealthy man can afford anything except a conscience.
A Ferengi might not care about having a conscience in business, but here on Earth, a conscience can be profitable. Case in point: Whole Foods Market (NASDAQ: WFM), where CEO John Mackey is a leader in the Conscious Capitalism movement. Mackey's company uses socially responsible business practices to gain a competitive advantage. Whole Foods treats employees well, leading to improved customer service and lower employee turnover, meaning lower costs for training and recruiting new employees. Whole Foods also has a higher purpose of improving the eating habits of its customers, not just a Ferengi-like obsession with quarterly profits. The company's embrace of this business model and corporate identity has helped shareholders who stuck with it earn over 900% in gains since the depths of the recession in 2008.
Rule 94: Females and finances don't mix.
Studies on investor psychology show that women tend to do more research on their investments, trade less often, and avoid herd-like mentality in the market better than their male counterparts. Even the great Warren Buffett invests like a girl, using these traits to build Berkshire Hathaway's (NYSE: BRK-B) portfolio of publicly traded stocks and wholly-owned subsidiaries into an economic powerhouse. Buffett has said (to string a few quotes together) that his "favorite holding period is forever" and his approach is "profiting from lack of change" because "time is the friend of the wonderful business." He does his research, doesn't invest in companies he doesn't understand, and intends to stick with the companies he does pick for the long haul. That mentality has increased Berkshire Hathaway's book value 586,817% (19.7% annualized) since 1965. Looks like the Ferengi are wrong on this one.
(Most of the rules are considered canon by virtue of appearing in the Star Trek: Deep Space Nine TV series. *The ones with asterisks are from the Star Trek books, considered non-canon by some fans. **There are many lists of the Rules on the web, mostly the same, but there are some differences from list to list; I only found the one with a double-asterisk documented here.)
Mike Steele owns shares of Berkshire Hathaway, Costco Wholesale, and Whole Foods Market. The Motley Fool recommends Berkshire Hathaway, Chipotle Mexican Grill, Coca-Cola, Costco Wholesale, and Whole Foods Market. The Motley Fool owns shares of Berkshire Hathaway, Chipotle Mexican Grill, Costco Wholesale, and Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!