Need vs Want: Or why your neighbours are drowning in debt

A recent article caught my eye today with some glaring headlines: “Canada’s middle class is on the brink of ruin”. Pretty dismal stuff, but unfortunately, probably true.

When I was a kid, I have a very distinct memory as it relates to debt. Debt was something that was considered with great deliberation. Typically, one used it to purchase very significant things – homes, and in the case of my father, machinery that helped him do his job. Other than those situations, it was to be avoided at all costs. The concept of debt was inherently negative – one was exposing oneself to risk, so a great deal of thought went into the process before the paperwork was signed.

However, I do recall one time that my parents broke this rule, and it was a result of my insistence. We were shopping for clothes before going back to school, and my mother and I were waging a cold war. She had a pair of jeans in hand that fit, but weren’t “cool”. I had in my hand a pair of jeans that would cement my place within the grade school pecking order, and they fit. The choice was clear, to me at least. I insisted that the un-cool jeans simply didn’t fit, but my mother saw right through me. Nonetheless, she eventually relented, and with a great sigh, pulled out the credit card. I remember her reluctance to do so, and the memory stayed with me for a long time: she was going out on a limb for a non-essential item, and it was a big deal.

In 2017, this little anecdote is quaint – but unfortunately, that’s all it is to many people. Credit today is two things – easy to get, and easy to use. Because of this, we confuse the concepts of “want” and “need”, something which gives me instantaneous migraines. When I hear someone close to me say “We need to buy a new…” , I know the statement is almost always incorrect. In some cases, we do need something. For instance, when the neighbour’s kids accidentally nails our window with the soccer ball, we do indeed need a new window. But in almost all other instances, what is really being said is “we want a new car”, or “we want a new toy”. With the easy availability of credit, the concepts of “want” and “need” have become so muddled, that many people are unable to really differentiate between them.

The linked article goes into much greater detail than I can provide (or want to) here, but it’s the confluence of easy credit and “keeping up” that keeps people chained to jobs or careers they despise. The net effect is a large segment of society that might not be living that healthy of a lifestyle. How happy can you be when you get up to go somewhere that you don’t want to really go? You try and make yourself feel better via some retail therapy, thereby guaranteeing that you will go back to your job or career tomorrow. In the meantime, you are likely unhappy, and your family is suffering the fallout. Perhaps Mom & Dad are both doing this. Wow – what an awesome environment for the kids.

Don’t get me wrong – I’m not against working. I believe it’s important to find something that engages the mind and the spirit. We can’t all sit around gazing at our navels. But when we begin to dislike (or despise) our work, and are working only because we are desperate to keep up with payments, something is going to bust. Many people begin their careers with noble intentions, but get derailed by buying things they can’t afford, which turns the tables on them. The individual that once showed up at the office because they wanted to pursue a particular career is now showing up because they are being pursued by an unsustainable debt load and lifestyle. The job or career that was once a choice is now a necessity, and if it goes, the house of cards collapses.

So, you might ask, what is the point of this rant? I think it can be boiled down to some fairly old-school wisdom, which I’m sure everyone has heard before:

  • If you really need something because it’s a necessity, buy it. You have to eat.
  • If you want something, ask why? What happens if you don’t have it?
  • When you go to work, remember: you are trading your life for money. You can’t get more life.
  • Since you are trading your finite life for money, try & do something you actually like.
  • Lastly, spend money wisely. You traded your life to get it, so you are really “spending your life”.

Why pick stocks ?

There are a great many finance blogs out there, and many of them are clear when it comes to “active management”. Various studies have shown that active managers rarely beat the market indexes, so the question is clear: if the professionals are lousy stock pickers, why try to do it for yourself ?

For many of us, that’s the only information we need in order become index investors. Nonetheless, as the saying goes, “variety is the spice of life”, and my approach has always included an element of active investing. To be clear, I am not against indexing. Rather, I’m simply explaining why I still actively seek out and pick individual stocks. To be even more clear, I’m not suggesting everyone run out and do the same (I doubt you will). Think of this as a glimpse into my view of the markets. If it’s entertaining, then I’ve done my job. If you learn something, as unlikely as that might be, then even better.

I follow a two pronged approach in my investment philosophy. I have two “buckets” of money: shorter term liquid investments which I can use for anything, and longer term and less liquid investments which are distinctly earmarked for retirement. Note that short term money can migrate to the long term bucket, but long term money never migrates the other way. Once it is “locked in”, it stays there. I should also clarify that “retirement” means “golden years” kind of retirement. In the meantime, I may not be working a standard 9 to 5 job, but I am not retired either.

The long term bucket is, for the most part, invested in companies that show steady growth and pay steady dividends – think consumer staples (Kraft), pipelines (Enbridge), and REITs. In this bucket, I am far less active, but I keep an eye out for bargains nonetheless. For instance, when oil started to go into a tailspin in 2015, I didn’t look at oil & gas producers, but rather at the pipelines that transported the commodities. The market, acting as it sometimes does, decided that pipeline companies should also be re-priced, despite the fact that pipeline tolls are designed to largely eliminate commodity risk. In any case, this bucket is not unlike an index fund, as it typically holds very large and very stable companies that change very little over time.

It’s in the short term bucket that I am most active. In this bucket, I favor the very small, the misunderstood, and the ugly. When all the stars align, it can be all three. Some of you reading this may be nodding, and you are probably saying that this is a classic deep value approach. This is partially true, as I will explain.

Early in my investing career, I tried various approaches, with various degrees of success. To make a long story short, I discovered that picking large cap value stocks at steep discounts was more difficult than it appeared to be. While there are sometimes bargains to be had, the market tends to be efficient with big names. I also tried momentum investing, with little success, as my charting skills were poor to say the least. Finally, over time I realized what should have been obvious – that the smaller end of the market, and the very small end of the market, was where true inefficiency came to hang out.

At this point, I’m sure many of you are no longer nodding in agreement, but rather shaking your heads in disapproval. Dreaded penny stocks, the veritable scourge of the investment world, are vilified by many, and for good reason. Many of them are over promoted shell companies that are intended only to enrich insiders. However, some of them are real companies with real intentions on making a better mousetrap. The trick is to separate the wheat from the chaff, and then, to separate further.

When I look at these very small companies, I tend to look for specific things such as:

  • A high level of management ownership that has stayed relatively steady or increased over time.
  • Management that has deep pockets. Think of Tesla and the way Elon Musk has backed it.
  • A company that is not just a resource or commodity company.
  • A history of operations. I’m looking for a company that has been at it for a while.
  • Low debt levels.
  • A minimal amount of outstanding options or warrants that will create excessive dilution.
  • A product that is relatively simple to adopt or implement, or clearly solves a problem.
  • A strategic advantage with respect to relationships or location.
  • Hopefully, a reasonable price to book value ratio.
  • No analyst or investment banking coverage. The idea is to be the first person at the party!
  • Lastly, a nice flat lined chart that indicates current investor sentiment is indifferent.

I may have missed some things, but this list encompasses the bulk of the factors I look for. Once I’ve found a potential company, I call them to see how approachable they are and to see if I can glean any more information. I call customers who use the product to ask about their experience with the company, and I call distributors who sell the product. I try and talk to anyone who deals with the company or uses the product to get a better understanding of how good or bad the product (and the company) is.

This process probably sounds time consuming, but I’ve come to consider myself a full time investor. This being said, I can assure you I don’t spend eight hours a day on the phone. Because the company in question is usually not a hot prospect at the time, the share price is usually fairly flat, so there is little risk that something material is going to happen right away. I will have these conversations over long periods of time, and will make notes accordingly. If the research turns up good information, I slowly add to my position. Rarely do I put in a large volume order, as with small companies, one can move the price quickly. Once I have a significant position, I monitor things – and wait, sometimes for a long time.

As you can imagine, this process is not for the faint of heart or for the impatient, so it tends to weed out those shareholders. But the payoffs, when they do occur, are well in excess of normal returns. While there is always the risk that a company can go bankrupt, thereby handing you a 100% loss, when these companies turn the corner, they pay off far beyond ones expectations. It only takes one to move an entire portfolio, as I discovered a few years after starting to pursue this “tiny ugly company” strategy. Over the period of 24 months, I watched the share price of one of my holdings move from under $0.20 to over $6.00. That single holding moved my entire portfolio significantly, and made up for everything else that was just plodding along.

So, at the end of the day, I’m an active investor almost entirely in the darkest, smallest recesses of the markets, as this is where one can truly find companies that may provide abnormal returns. By purchasing a basket of companies like this, risk is diversified. It’s not necessary for all of them to do well, or for that matter, for the bulk of them to do well. While I can never say that “XYZ Corp is going to go from $.25 to $100”, I do know that there is a reasonable probability that some of these will muddle along, some will go bankrupt, and one or two will perform beyond my wildest expectations. My job is to stay curious and keep looking for the small, the ugly, and the misunderstood, as these are the companies that will provide those abnormal returns over the longer term.

Grey what ?

Some of you might be asking this question, concerned that you’ve stumbled onto some really weird bird watching website. Well, don’t worry. This website might yet be weird, but it’s definitely not about bird watching.

Some time ago, I read a book that you might be familiar with, “The Black Swan” by Nassim Nicholas Taleb. The gist of the book is this: that in life, and particularly in the finance world, we as individuals are beholden to impactful & unpredictable events. While we often think we can predict what will happen, we are simply bad at predicting, or we characterize our predictions incorrectly. The net effect is that we, believing we can predict outcomes, get blindsided by what we can’t see, can’t understand, or just don’t understand properly.

These unanticipated events are “Black Swans”. The title refers to the fact that at the turn of the century, people believed all swans were white because no one had seen a non-white swan. The fact that a breed of black swan was eventually discovered highlights the fact that if one has never experienced something before, it doesn’t mean it can’t happen.

The_black_swan_taleb_cover Continue reading → Grey what ?