Common Stocks and Common Sense: The Strategies, Analyses, Decisions, and Emotions of a Particularly Successful Value Investor

by Edgar Wachenheim

With the hope that others will benefit from my approach to investing, this book will explore what I believe to be the reasons for my relative success and will describe the reasoning behind the investment decisions that I made over the years.

the U.S. economy grew at roughly a 6 percent annual rate: about 3 percent from real growth (unit output) and about 3 percent from inflation (increases in prices).

If future growth is somewhat dampened, then corporations will not need to reinvest as much of their cash flows back into their businesses to support growth.

If future growth is slowed, then there should be more free cash available to the company to invest or share repurchase

Many consider volatility to be a risk. Importantly, when thinking about risk, I draw a sharp distinction between permanent loss and volatility.

This leads me to another important positive attribute of common stocks. An investor can decide the exact times he wishes to buy and sell a stock, and the only determinants of his success are the cost of the stock at the time of purchase and the price of the stock at the time of sale.

My specific objective is to achieve average annual returns of 15 to 20 percent without subjecting our portfolios to large risks of permanent loss.

Specific objective of Edgar

The strategy is to try to purchase deeply undervalued securities of strong and growing companies that hopefully will appreciate sharply as the result of positive developments that already have not been largely discounted into the prices of the securities.

We typically purchase shares in a company in anticipation that one or more positive developments

will drive the shares within the next few years, and we then sell the shares after the positive development (or developments) has occurred and has been substantially discounted into the price of the shares.

Positive developments can include a cyclical upturn in an industry, the development of an exciting new product or service, the sale of a company to another company, the replacement of a poor management with a good one, the initiation of a major cost reduc...

The above strategy of predicting positive changes makes common

sense.

At any one time, the price of a stock reflects the weighted opinion of the...

A company that has a leveraged balance sheet (large quantities of debt relative to its cash flows and assets) may not have sufficient cash during difficult times to pay the interest it owes on its debt,

A company whose value is dependent on a single technology might permanently lose most of its value

if he holds the shares for many years, most

of his returns will come from the growth as opposed to any change in the share’s price-to-earnings (PE) ratio.

good investor needs to be highly confident about his ability to make decisions, because investment decisions seldom are clear and usually are muddled with uncertainties and unknowns.

I believe that a successful investor must be adept at making contrarian decisions that are counter to the conventional wisdom, must be confident enough to reach conclusions based on probabilistic future developments as opposed to extrapolations of recent trends, and must be able to control his emotions during periods of stress and difficulties.

In fact, I believe that the inability of most individuals to invest counter to prevailing sentiments is habitual and, most likely, a genetic trait.

However, in follow-up conversations, Danny often will mention that he is waiting for some signal that the problem has eased before purchasing the stock.

In my opinion, reaching rational decisions in a probabilistic world requires confidence. I have observed that investors who lack confidence often delay making decisions in quest of additional information that supports

their views.

To maintain my confidence and to guard against decision regret (becoming distraught over opportunities that were missed or over purchases that were unsuccessful), I draw a large distinction between the correctness of my decisions and the outcomes of my decisions.

When an investor is barraged with particularly bad or good news, he can reread the memos, notes, and models he wrote before the occurrence of the news. He then can ask himself three questions: What really has changed? How have the changes affected the value of the investments under consideration? Am I sure that my appraisal of the changes

rational and is not being overly influenced by the immediacy and the severity of the news?

My conclusion was that, if the government stabilized prices at a relatively high level in a year that farmers produced excess supplies of a crop, the farmers would have economic incentives to continue planting large quantities of the crop.

Impact Of consequences

We are disinterested in short-term results and thus have the luxury of focusing our research and purchases on the much less competitive universe of stocks that have less promise of near-term appreciation, but that have exciting longer-term potential. This gives us a competitive edge.

Opel changed IBM’s pricing policy by offering to sell used mainframes at deeply discounted prices.

Akers initiated a series of early retirement programs, offering large severance packages to employees willing to leave the company. Of course, many of the most capable employees—those readily able to find other jobs quickly—

Unintended consequence

IBM no longer was a growth company with competitive advantages that led to high profit margins. Thus, it no longer deserved to sell at a high price-to-earnings (PE) ratio. However, if the company could become cost competitive by sharply reducing its head count and by selling excess plants and office buildings, it could emerge as a large and powerful company that should earn a reasonable return on revenues.

1993, announced his resignation. Lou Gerstner was his replacement.

told the audience of reporters that he had the courage to take tough steps.

I concluded that Gerstner might be able to reduce costs by $5 billion. After taxes at a 32 percent effective rate, the cost reductions would add about $3.4 billion to net earnings, or about $1.50 per share based on the 2.29 billion IBM

We usually purchase stocks because we believe that one or more positive changes will trigger a sharp appreciation in the price of the stocks. In this case, we hoped that IBM would announce a definitive plan to substantially reduce its costs.

As a result, IBM’s per-share earnings increased materially faster than its net earnings. I had failed to consider the repurchases.

My reasoning was that the combination of the share repurchases and the improved margins would lead to higher earnings per share (EPS) than was generally predicted by Wall Street.

While I was very wrong to sell the shares in 1994 at about $16, I was very right to purchase them again 15 months later. IBM earned $2.51 per share in

Over the years, I have learned that we can do well in the stock market if we do enough things right and if we avoid large permanent losses, but that it is impossible to do nearly everything right.

I try not to fret over mistakes. If I did fret, the investment process would be less enjoyable and more stressful.

most wonderful businesses can be held forever because most wonderful businesses become less wonderful over time—

But I am interested in the opinions of the Wall Street analysts, not because they will directly influence an investment decision, but because they collectively reflect the conventional wisdom on a security and therefore help me understand why a security is selling at the price at which it is

selling.

focus on areas that seem to be the most critical determinants of what the company will be worth in two or three years.

I became interested in Interstate in the fall of 1985 when a friend mentioned that Howard Berkowitz purchased 12 percent of the company’s outstanding shares, became chairman of the company’s board, and hired a new CEO, who was convinced that he could materially improve the company’s profits.

It is said that a shareholder makes money off the income statement, but survives off the balance sheet, and I agree.

A shareholder makes money on income statement but survives of balance sheet

I look for signs of financial and accounting strengths. Debt-to-equity ratios, liquidity, depreciation rates, accounting practices, pension and health care liabilities, and “hidden” assets and liabilities all are among common considerations, with their relative importance depending on the situation.

The competence, motivation, and character of management often are critical to the success or failure of a company.

After trying to get a handle on a company’s balance sheet and management, we usually start studying the company’s business fundamentals.

The insight permits us to separate the information that is critical for decision making from the information that is of secondary or tertiary importance.