Tenets of Investing #2 Focus on turnaround plays with high potential returns

This is the sixth part of my 10 part series on the tenets of my investment philosophy. I believe that investing without a game plan is equivalent to a baseball player swinging with his eyes closed. Sometimes contact will be made, but not having a game plan makes the at bat that much harder. I’ve set up a Tenets of Investing page where you can click to check out all 10 of my tenets. And just to screw with you guys, I’m going to write about them in a random order.

Most investors are pretty similar. They look for mature, blue chip companies, preferably ones that pay a dividend, look to buy them for a somewhat cheap price, and look to get about a 10% return per annum. These types of companies are perceived as safe, steady investments, investments that have stood up to the test of time.

I used to be one of those investors, with holdings like Telus, Reitmans and Investor’s Group still sitting in my portfolio. Some of my blue chip stocks made money, others have basically done nothing except paid the dividend. An investor can have success with this method, the caveat being that companies of such size are unlikely to beat the index by any significant amount, mostly because they make up most of the index.

When one spends time researching the investors that have blown away the index for a period of years, one style of investing is prominent- value investing. Buffett, Munger, Watsa, Taleb and Bruce Berkowitz- to name a few- have some of the best records over long periods of time, amassing those returns using some form of value investing. Even my boys over at Contra the Heard have crushed the market using a special kind of value investing, contrarian investing.

I choose to aim for high potential returns, rather than the 10-20% it seems like most investors strive for. I won’t even look at a stock if I don’t think it can go up a minimum of 50%, with my target price often set at 200-300% above my purchase. Just look at recent purchase Duoyon Printing, purchased on Friday at $2.80, with a sell target of $9.00. I choose to swing for the fences when I invest, rather than being content with singles and doubles.

It would be unrealistic for an investor to buy one of the blue chips I mentioned above with the expectation of a double or triple in the stock price. Most blue chips do not realistically have that potential. If you’re looking for the big returns, you have to look at the companies that are, for whatever reason, broken and beaten down.

There are many reasons why a company can enter into contrarian territory. Perhaps the whole sector is unloved- the U.S. housing sector and shipping stocks are two examples of that. Perhaps the company has taken on too much debt or has been losing money recently and the market isn’t bullish on their prospects. Sometimes contrarians will find a company that appears unloved for no tangible reason.

If a company has fallen 50-95% from it’s previous highs then it has the potential to go back to those highs, provided they fix whatever is keeping the company down. Like muscle in the human body, regaining muscle is much easier than gaining that muscle in the first place. Once the company starts to get on the right track, institutional investors start to recognize the company again, helping propel it even higher. Given enough time, a company can go from contrarian favorite to hot stock.

In 2003, Apple shares hit a low of just over $7 per share (split adjusted) before beginning their stratospheric rise to today’s levels. At that point PCs dominated the computer market, the ipod was in its infancy and the iphone or ipad hadn’t even been dreamed of. The company had spent the late 90s and early 2000s trading at 2-3 times the 2002-03 lows. Even Apple was once a contrarian stock.

Tenets of Investing #1: Focus On Low Debt And Great Balance Sheets

This is the fifth part of my 10 part series on the tenets of my investment philosophy. I believe that investing without a game plan is equivalent to a baseball player swinging with his eyes closed. Sometimes contact will be made, but not having a game plan makes the at bat that much harder. I’ve set up a Tenets of Investing page where you can click to check out all 10 of my tenets. And just to screw with you guys, I’m going to write about them in a random order.

Like my investing idols over at Contra The Heard, I spend a lot of time looking at the strength of the balance sheet for any of the companies I’m interested in investing in.

The reason is two fold. First of all, when I invest in a company that’s been beaten down, often profits have been beaten down as well. A company may be breaking even or losing money by the time it gets beaten down enough for me to have a look at it. If a company is in that situation, getting back to profitability is a much easier task than if the company has a bunch of debt it has to pay to service.

The other reason is if a company is in trouble and they have significant debt, refinancing that debt can become difficult. Nobody wants to lend money to a company that is having problems. If the company can find a way to refinance, often it’s at an inflated interest rate. Returning to previous form is much more difficult when debt service costs have gone though the roof.

If a company has a great balance sheet, generally that gives me the message that management is a more conservative bunch that shuns the idea of taking on a lot of debt to do something drastic, like acquiring a competitor. One of the biggest risks in buying shares in contrarian names is company specific. Anything that gives me assurance that the company is going to try to recover without taking on much debt is a good thing.

Much like on an individual’s balance sheet, debt takes away choices for a company. Perhaps a great opportunity comes up to buy a competitor selling for a great deal. If they have too much leverage on their balance sheet, they might not get the debt they need to make the acquisition. Costs to service debt can take away from research into new markets or products, making a company’s return to prominence much more difficult.

It’s quite often that an investor will find a company trading on an attractive basis from a book value perspective, yet that company will be carrying some debt. How much debt is too much debt? Should an investor shun companies completely that have debt?

There’s no easy answer to how much debt is too much. Depending on the industry, I’m tolerant of debt. A REIT will almost always have debt on the balance sheet. So will a utility or a bank. The key is to have a look at historical debt levels and the indebtedness of competitors. If the company’s debt to equity ratio greatly exceeds their competition, then maybe it’s a company to avoid.

Saying that, some of the best recoveries in recent memory have come from companies that seemed like they were drowning in debt. Teck Resources recovery from their low at below $5 to their recent highs of over $40 was remarkable in both its speed and the amount it returned to investors brave enough to buy when the future looked darkest. One may characterize that as speculating. Of course, one may also label contrarian investing as speculating as well.

I don’t hate debt. Companies need to borrow for all sorts of reasons. I just hate it in excess.

Tenets of Investing #8- Diversification

As the old saying goes, the only free lunch in investing is diversification. One of the best things an investor can do is to diversify their holdings across different sectors to minimize risk.

I’m not telling you anything new. In fact, just about every one of you knows that diversification is important. But how far should an investor go? Besides diversification across equities in various sectors, an investor has to think about other asset classes such as debt, real estate, commodities or derivatives. If you’re feeling particularly frisky, you could even invest in collectables, art or wine. There are countless ways to diversify one’s portfolio and there simply isn’t enough time to fully research them all. What’s an investor to do?

Stocks are simple to diversify. All you would need to do is invest your equity positions in various broad market ETFs that track exchanges like the S&P 500 or the Russell 2000. If you’re someone who invests in individual stocks, diversifying is a little tougher, but can be easily done given a bit of time and some research.

The question is just how far one needs to go to obtain an adequate amount of diversification. How many equity positions is enough? 15? 25? 50? Even more? The guys at Contra the Heard try not to have any more than 25 names in their portfolio, often having less than 20 companies they’ve invested in for the newsletter. Most mutual funds will have positions in over 100 individual companies. While diversification is somewhat of a personal decision, it is very possible to be over diversified.

Just about everyone has too much of their net worth tied up in one “asset”- their house. If the value of their home goes down any amount of value, their net worth is affected greatly. Yet many people spend their entire lives investing primarily in one thing, like real estate, and do just fine. They have too much of their net worth in one asset class and yet end up with a substantial net worth. Are these people doing things wrong? Or are they simply putting all their eggs in one basket that they observe constantly and know like the back of their hand?

While I believe every investor should diversify, the question about how much they should is best answered individually. If somebody doesn’t fully understand certain asset classes, should they really be putting hard earned cash into that type of asset? And if you’re really good at investing in one asset class, then is moving into other types of investments really that good of an idea?

My dad is really good at investing in real estate. He’s built most of his net worth from buying rental houses. If you were to look at his balance sheet, he would have a large percentage of his net worth in real estate. From a traditional diversification perspective, he’s woefully undiversified. Yet this strategy has worked out extremely well for him. What’s an investor to do?

This is one of those things that is an individual choice. Some people are very good at putting all their eggs in one basket and doing a terrific job with that basket. Others need to diversify among many different asset classes because of a fear of missing out on one of them. Whatever people choose, we can all agree that having a large part of their net worth in one stock or their principal residence isn’t the best course of action.

Tenets of Investing #4: Exercise Patience

This is the second part of my 10 part series on the tenets of my investment philosophy. I believe that investing without a game plan is equivalent to a baseball player swinging with his eyes closed. Sometimes contact will be made, but not having a game plan makes the at bat that much harder. I’ve sent up a Tenets of Investing page where you can click to check out all 10 of my tenets. And just to screw with you guys, I’m going to write about them in a random order.

When it comes to a lot of things in real life, I’m not very patient. I get bored when I have to wait for things to start. I get angry when the person driving in front of me is going too slow. One thing people have always teased me about is my impatience.

For some reason, when it comes to investing I can be incredibly patient. I’m more than happy to wait in the wings, putting my cash in money market accounts and just sitting tight for the right opportunity. When an opportunity presents itself, I’m ready to go.

When I get in trouble as a value investor, it’s when I buy something on the way down thinking the bottom is very near. Like many other investors, I look at how much the stock is down from its high, convince myself it can’t possibly go down anymore, pick some up, and promptly watch it go down some more.

While I believe it’s a sucker’s bet to try to consistently time the market, an investor needs to buy a company when it’s cheap. Look at the 10 year chart. Is the company trading at the bottom of their 10 year range? If they are, find out why. Either a company has been unfairly punished by the market or there’s something legitimately wrong with it.

The beauty of buying something when the present looks the most bleak is when the future becomes a bit more rosy, the stock reacts with a nice move very quickly. For the people who have held it for years and watched 75% of the value erode away it’s a bittersweet move, yet if you bought close to the bottom you are laughing.

The point of exercising patience isn’t buying companies simply because they’re the cheapest they’ve been in years. What you want to do is buy companies that have a track record of doing things right at the cheapest price possible.

Or, do it another way. Identify companies you want to buy, companies maybe you believe have that special competitive advantage you really like as an investor. Then look at the 5 or 10 year chart and vow not to buy that company unless it gets to close to that low point. Only buy it then.

Being patient is one way to maximize your investment returns. If you invest like this, often you’ll sit on a stock for years before it does much. That’s okay if you’re buying beaten up names and hoping for a 100-400% return. If you’re looking for 5-10%, this probably isn’t the method for you.

Tenets of Investing #3: Dividends

This is the first part of my 10 part series on the tenets of my investment philosophy. I believe that investing without a game plan is equivalent to a baseball player swinging with his eyes closed. Sometimes contact will be made, but not having a game plan makes the at bat that much harder. I’ve sent up a Tenets of Investing page where you can click to check out all 10 of my tenets. And just to screw with you guys, I’m going to write about them in a random order.

I’m really going to anger my pal Dividend Growth Investor with this statement, but I’m going to make it anyway. Dividends are not the be all and end all when investing.

Please don’t think I’m anti-dividend. Like my other pal Kevin O’Leary, I enjoy when companies “pay daddy”. Dividends are the nice payments you receive while waiting for the stock price to go up in value. When you’re a value investor like me, often that waiting period can be a long time. While dividends are nice, I believe investors should view them as a bonus rather than a necessity.

There are two components to return on investment. One of them is capital gains, the other is income. Some investments should focus on capital gains, while others should focus on income. And some investments should incorporate parts of both income and capital gains. That’s the sweet spot of dividend investors. That’s their game plan, not mine.

For someone like me, I’ll buy a company that’s trading below book value, yet isn’t making any money. In a situation like that, I’m more interested in buying assets worth a dollar for fifty cents. As long as I believe the business has potential for turnaround, I’ll buy it, earnings and dividends be damned. Not every investment needs a dividend to be considered attractive.

Saying all that, a company gets a bonus thumbs up from me if they pay a dividend. While getting paid to wait is a plus, it’s not imperative. If I was presented with two equal companies, with one being a dividend payer and the other doesn’t, I would pick the dividend payer every time. It’s just not very often that we’re given that choice as investors.

I’ve come to the conclusion that a lot of the stocks I’ll find attractive won’t pay dividends. I’m okay with that, I’m just hoping to find some companies I like that pay daddy.