Today's comment is by John Pugsley, Chairman of The Sovereign Society and editor of the Sovereign Society's brand new investment service, Stealth Investor.
Dear A-Letter Reader:
To entertain attendees at the upcoming annual Berkshire Hathaway shareholders meeting, Warren Buffett announced Patrick Wolff, two-time U.S. chess champion, will take on all comers in groups of six – while blindfolded. The world's most fabled investor may be making the point that even the impossible can be easily done if you know the game. Certainly, Buffett's record confirms that in the investment game he's a champion.
Over the last 41 years (that is, since Buffett and his partner Charlie Munger took over) the book value of a share of Berkshire Hathaway grew from $19 to $59,377, a rate of 21.5% compounded annually. The company now has a value of about $138 billion.
While Buffett was performing his magic, the S&P 500 grew at only 10.3%. Had you invested the same $19 during the same time in S&P, your investment would have grown to a little more than $1,000.
If the majority of Wall Street pros can't do it, can individual investors hope to equal or exceed the returns of a company like Berkshire Hathaway?
Compete head-to-head with Wall Street and Buffett, and your odds of outperforming them are dismal. Companies listed on the U.S. exchanges are tracked and examined with the financial equivalent of electron microscopes by armies of analysts. There is an intense competition to find undervalued stocks in this arena, and individuals rarely have the resources to compete. However, apply fundamental principles to fields Wall Street and Buffett ignore, and you can beat their performance.
The savvy independent investor can play in an arena that's closed to the big players, where there are outstanding, undervalued companies that are too small to interest institutions and brokerage firms, and other incredible companies that are legally verboten to licensed brokers because they are not fully registered with state and federal regulators. Trust me on this: over the past eighteen months, I've identified two dozen such overlooked gems. The average gain of the group? Just under 100%.
In brief, here are the five criteria I apply:
1. Look for companies trading at a substantial discount to intrinsic value. As Buffett wrote in An Owner's Manual for Berkshire Hathaway, "Intrinsic value … is the only logical approach to evaluating the relative attractiveness of investments and businesses."
2. Search for smaller companies, micro-cap or even nano-cap, that have verifiable assets and a high probability of future earnings. Generally, they'll be under $1 billion in market capitalization, and usually well under $100 million. Many are out there with market caps under $10 million. As U.S. markets tend to concentrate on larger cap companies, often these stocks will be non U.S.
3. Watch for companies that are thinly-traded and not institutionally owned … sometimes these companies are one step away from being privately held. There is less competition for information, and hence inefficient markets.
4. Look for industries that are out of favor, e.g., when the mining business is out of favor, look at mining, when Argentina is experiencing political turmoil, look at Argentina. (It's the old concept of “buy when blood is running in the streets or in the industry.)
5. Most importantly, concentrate on companies ignored by Wall Street, and companies that licensed brokers and advisors are prohibited from recommending because of regulatory censorship.
Here's one example:
If you were searching for the single most beat down stock in the world, it makes sense that you would search for an out-of-favor industry in an out-of-favor country and a pariah of a company.
Three years ago the out-of-favor industry was mining, and the asset in greatest disfavor was uranium. Its bear market began in 1982, and except for a sucker rally in 95 and 96, and didn't end until 2003, a 21-year-long bear market. Wise investors searching for out-of-favor industries and markets would have looked for Australasia, mineral exploration, and particularly uranium.
In that context, a little uranium exploration stock listed in Australia called Paladin Resources Ltd. (PDNAU) would have appeared. If you bought Paladin in 1997, the first time this analysis pointed to it, you would have paid AU$0.07. From there it had an inexplicable run up to AU$0.14, before collapsing all the way down to AU$0.015 in October 2003. As the uranium and the mining stock market recovered, and as industrial world demand for developing markets recovered, Paladin recovered from AU$0.015 in Oct 1993 to AU$0.70 in Oct 2004, and is currently at AU$3.63.
There are other Paladins out there. Filter through companies on the over-the-counter market, on the pink sheets, and on smaller exchanges in countries like Canada and Australia. The Internet and the amazing search engines like Google offer every individual access to information that would formerly have required cadres of analysts to uncover.
It's doubtful that you or I could ever play chess blindfolded, or match Buffett's record if we had billions to manage. However, in this information age, individuals willing to apply time and fundamental analysis have a very real opportunity to beat the markets, and even beat Buffett's remarkable record.
JOHN PUGSLEY, Chairman,
on behalf of The Sovereign Society