Saturday, December 9, 2017

Book review: "Common Stocks and Common Sense" by Edgar Wachenheim

Common Stocks and Common Sense has the same format as Peter Lynch's One Up on Wall Street: it's a loose autobiography of a fund manager with a few case studies, some homespun philosophy, and a lot of rule-of-thumb advice.

Unfortunately Wachenheim is no Lynch, and I strongly recommend against reading this book. I'm sorry to be so harsh, but most of the ideas in Common Stocks are dangerously simplistic--this is an investment book by an investment manager who doesn't really understand investing.

I'll give a couple examples.


Centex

Wachenheim began investing in property developers in the 1990s. In 1999, he bought shares of Centex on the assumption that the largest developers were becoming growth stocks: the savings-and-loan crisis in the early '90s had cut off credit to many smaller developers, so the biggest companies were taking share and growing much faster than the sector as a whole. Centex was trading at $12, but he forecast that it would reach $63 in a few years as sales rose in a straight line, margins increased with scale, and investors rewarded Centex with a higher price-to-earnings ratio on higher earnings.

"Because the homebuilding industry was becoming a growth industry... I valued Centex at 12 times earnings [in 2003]," he writes, adding, "I was literally jumping up and down with excitement."

There are a few problems with this rationale:
1.) The savings and loan crisis was over by 1999, so it wouldn't have been an impediment to smaller developers from then on. If anything, small banks might have been more willing to lend to developers because they were losing out to larger banks in mortgage origination, a volume business, and needed other places to put their deposits to work.
2.) Developers earn much of their money from land appreciation. If they buy a plot of land and then land prices rise faster than their cost of borrowing, they can earn huge profits. Since building houses is a competitive business with low barriers to entry, land appreciation is sometimes their only source of profit. And land doesn't care who owns it--a large builder doesn't have land-appreciation economies of scale. So when Wachenheim forecast steadily rising margins, in my opinion he misunderstood how these companies make money.
3.) Profits from land appreciation are mean-reverting. If land prices surge, developers can earn fat margins on their existing inventory, but when they buy new plots of land they'll have to pay the new, higher prices and margins will come back down--assuming prices don't rise perpetually.


Wachenheim concludes by writing:
In the fall of 2005, Centex’s shares were selling at about $70. We had earned close to a sixfold profit on our investment. I should have been ecstatic, but I was not. The shares still were trading at far less than 10 times earnings. 

The investment was a complete winner, but I felt that it could have been even more profitable if the housing bubble had not occurred because the homebuilders eventually would have earned respect and sold at much higher PE ratios.


Union Pacific

Wachenheim bought shares of Union Pacific in early 2004. Here I'll let him speak for himself:
[Union Pacific] did not appear to be a particularly exciting investment opportunity, but the stock market and our stocks had been strong in 2003, and we did not have alternatives that appeared to be more attractive...

There was another reason to own shares of Union Pacific rather than holding cash. Over a period of many decades, the stock market, as measured by the Standard & Poor’s (S&P) 500 Index, has enjoyed an average annual total return of roughly 9½ percent—and our best guess was that returns could average somewhere around 9½ percent over the next few decades. When we purchase a stock, we believe that it will appreciate by far more than the stock market appreciates. However, what if we are wrong and the stock appreciates only as much as the market? Then, if the stock is typical, it should earn an average annual return of about 9½ percent over time, which is much better than holding cash.


One important lesson

While the specific ideas in Common Sense are useless, the book does teach one very important lesson: that intellect isn't only determinant of investing success.

Wachenheim has been a fund manager for 30 years and has handily beat the S&P 500 index during his career. His ability to do so despite a weak understanding of the stock market shows, in my opinion, the value of intuition. By intuition, I mean a mix of common sense and knowledge that one has gained from experience but can't necessarily articulate. Wachenheim writes that he sold Centex in late 2005, at the exact peak of the housing bubble, because he thought housing starts had risen too quickly and there were anecdotal signs that the market was overheating.

Notably, Wachenheim's idea about large property developers having economies of scale became popular after the housing bubble took off. Having a bad idea can be profitable if many other people later adopt the same bad idea.

4 comments:

  1. Another funny quote from the book, describing a contentious meeting he had with Centex's CEO:

    I was frustrated. I was angry. My father always told me to slowly count to 10 whenever I was angry, and then the anger would disappear. I counted to 10 very slowly. I was still angry. I counted to 10 again. I remained angry and frustrated.

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  2. another great post! are you getting more active blogging now?
    Personally, I love Howard Marks, but thought his book The Most Important Thing was so derivative as to be nearly useless and I can never understand why anyone with above a middle school education heaps praise on that one. If you haven't learned that investing is an expectations game by your second day in the industry, you should get out.

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    1. Thanks. I've had a killer case of writer's block, but I hope to write more from now on.

      Completely agree about Marks... his track record speaks for itself, but a lot of his writing is just eloquent statements of the obvious

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  3. I have to admit I liked Howard Marks book.

    I mean nothing really new, but it vindicated me in my approach. He might not walk his talk though.

    Regarding this post, and me too wished you posted more frequently, although our investment style is totally diametral.

    "By intuition, I mean a mix of common sense and knowledge that one has gained from experience but can't necessarily articulate."

    I think what you are talking about is EQ. Too many in this business have a high IQ, but the missing part is EQ.

    What I am basically saying is that family with money should not send the brightest kid into the money management business, but the one who has high social competence.

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