Over the past few days, I’ve been trading emails with Jeff Annello, who writes at Circle of Competence. He describes himself as a young investor trying to apply the teachings handed down by value gurus to his own investing, and if his writing is any indication, he has learned well. Here, Jeff shares some thoughts on his investing philosophy as well as a couple of stock picks.

James Cullen: I guess the first thing I’m wondering is that, given your blog name - Circle of Competence - and philosophy to invest in businesses that are easy to understand, what area of the market (be it an industry or asset class) do you see the greatest number of investors ignoring those principles?

Jeff Annello: Where do I think people stray from their Circle of Competence? I think this is an issue in nearly every area of the financial markets. Peter Lynch liked to point out how retail employees invested in pharmaceuticals and pharmaceutical reps bought retail companies because someone else told them to, not because they had any special sphere of understanding in those areas. This is a major mistake, one of the most common that “active” investors practice. That said, If I had to choose some areas where it happens more than others, in the stock market, I would go with financials and pharmaceuticals.

I say financials because I have made the mistake myself over and over in the past, and only recently began coming to my senses. Warren Buffett has said numerous times that investing in the financial arena is heavily dependent on your trust of management, because as we’ve seen in the recent crisis, it’s nearly impossible to decipher the financial statements of a purely financial company. To make a proper equity (or debt) investment, you must thoroughly understand the assets and liabilities of a corporation, and most financials are very, very tough to understand. There are no factories or stores they can liquidate (in most cases) on the asset side, and their liabilities are often “counted” as equity, when in fact they are not. Subordinated debt has no claim on ownership in the enterprise, but its often counted in capital ratios for various financial entities. Things like that, over time can trip you up. It’s easy to make a huge mistake on a financial company because they are highly leveraged entities, however most people do not grasp that fact.

Regarding pharmaceuticals, it is nigh impossible to predict or accurately value the pipeline of any drug company. Betting on the success of early stage drugs is akin to gambling in my mind. Many people believe in the value of Drug X, but in reality it is very hard to value the prospects of that drug. That said, periodically pharmaceutical companies can get cheap enough that you don’t even need to value the future drugs. However, 90% of the time, people buy drug companies on flawed or incomplete knowledge.

Cullen: I’m completely with you on pharma - an area I’ve only strayed into once, with a single-drug company going into patent expiration that was really just a DCF runoff situation - not all financials are opaque. Now, it’s important to differentiate between the highly levered interest-rate financials, the black box derivatives companies, and then the simpler financials that are more service-oriented, but there is one company I think we both agree on that falls into the former category and is a buy, and that’s Primus Guaranty (PRS). Primus writes credit derivatives, something which seems very complex on the surface, so what is it that draws you there?

Annello:I agree with your statement that not all financials are opaque. Fortunately, every rule has its exceptions, and Primus Guaranty is, in my mind, an exception. What drew me to a company like Primus was its simplicity and valuation. I went through a couple of mental checks before digging deeper. Can I understand this company? Check. Does it look like it could be very cheap? Check. That’s all I need to see before I look further. Both are equally important.

It was all downhill from there. I challenge you to read Primus’ K’s and Q’s and tell me that you really don’t understand what the company does and what their exposures are. The financial statements are very clear, very lucid, and the company simply does two things. One is selling insurance on the default of (97%) investment grade corporate entities (the CDS business), the other is managing CDO’s. You get a guy who helped create the swap market running the place, a man in the RISK Hall of Fame. I won’t go through the whole thesis again, but the point is that Primus passes all of my mental filters. Do I throughly understand the company? Is it selling well below a conservative calculation of normalized business value? Do I believe management is competent and honest, enough to maintain or grow business value?

If the answers to those three questions is “yes,” I’ll buy it. Primus was a yes. It sounds simple, but it takes a lot of work and intellectual honesty to find a company that is an unequivocal yes to all three questions. If it’s a maybe on any of the three, it’s better to pass.

Cullen: And on the opposite end of the first question, where do you think the small retail investor can most effectively exercise their knowledge to uncover profitable investing opportunities? Do you see more benefit in sticking to the consumer side with products one purchases, or the employment side with companies in related lines of work?

Annello:There really is no one industry or asset class where retail investors can prosper. It’s not enough to have visited the store and enjoyed their products. Peter Lynch’s words are frequently misinterpreted to mean that if you enjoy the products or work in the industry, you can buy the stock. That’s a gross over-simplification. You have to do your homework, and lots of it. If you don’t have the time or inclination, you should be investing in the Hall of Fame mutual fund managers or index funds.

Retail investors have two major advantages. One is that we have a very small asset base to invest. Commissions are so low now that a small asset base allows you to “go anywhere,” and look for value under any rock. That’s a massive advantage over the market. The other is the ability to be patient. A retail investor can sit and bide their time, play golf, go on vacation, and then one day Sears (SHLD) hits $82 a share and you say, holy goodness! Then you buy. When there’s nothin’ to do, don’t do nothin’.

The most important things are to stick to what you understand and don’t lose money. Maybe you work at Pfizer (PFE) testing drugs, maybe you love video games, maybe you have been reading retail annual reports since you were a lad. OK the last one is unlikely, but my point is that you need to stick to your circle of competence. That doesn’t mean that, over time, you can’t expand that circle. It does mean that, in the here and now, you need to draw that circle and pretend you are 7 again and playing the “carpet is lava” game, except now the lava is anything outside your circle of competence. That’s what any investor can do. You need to read all of the public information and say to yourself, could I have a meeting with management to talk in depth about this company and not look like an idiot? You don’t have to actually do that, but it’s a good mental filter to utilize. Think like you were actually buying this business tomorrow and you’d have to begin making strategic decisions. There’s a certain level of understanding you’d need to attain to feel comfortable with that.

Cullen: You mention SHLD, a stock you own and seem to like at this price. Lots of value investors are drawn to the company thanks to Eddie Lampert’s track record as well as the hidden or undervalued asset of Sear’s real estate holdings. The market price of SHLD today settled at 1x book - not tangible book, but Sears has several well-known brands that are carried as intangibles. Is there something specific you see as a catalyst for Sears, or is this just going to be a time arbitrage situation where you get to take advantage of having a shrewd capital allocator like Lampert at the helm?

Annello:Sears is such an interesting case study for investors to look at, whether you choose to invest in it or not. The polarity of investor sentiment on Sears creates an opportunity that, if you are right, if your analysis is correct, there is a tremendous opportunity to make money.

The deal with Sears is that there is massive uncertainty as to what constitutes their future business. Are they a retailer? Are they a holding company? Will they become a REIT? Fortunately, this uncertainty is what creates opportunity. Instead of trying to figure out what Sears is going to become, better to figure out whats Sears is going to be worth. On the downside, Sears obviously has the real estate. Now, I haven’t done an in depth study of its real estate holdings but a little logic tells me that with hundreds of owned locations and 100 year capital leases that are akin to ownership, there is billions in valuable real estate that Sears holds. Target, Macy’s, JC Penney, these companies would love to take locations of Sears’ hands. Sears can create value through operating its new real estate arm as a REIT. Sales, subleases, sale-leaseback transactions, there are numerous ways to create wealth with owned real estate.

In addition to real estate assets, their brand names have tremendous value that has yet to be realized. If Sears’ retail operation continues to struggle, the brands become more valuable being utilized in another capacity, being sold through other mass retailers. Diehard, Craftsman, Kenmore, Lands End. Eddie has already made it clear he is willing to do this, so I’m not picking that strategy out of thin air.

The conclusion of the thesis is that Eddie Lampert is running the place. You can question his retail acumen, but as a pure capital allocator he has few peers. So now, one of two situations play out. A. The retail stores are turned around and the company gushes cash, in which case the equity is
worth multiples of the current price. With decent margins, you can squeeze a lot of cash out of $49B in Sales.

Situation B is that the holding company structure takes effect, and a genius capital allocator begins to use the assets to create value. Eddie has all the incentive in the world to make either A or B play out, and I don’t see shareholders losing. The great thing is, no matter what the market does, a successful investment in Sears is predicated on Sears’ business success, not changing market sentiment. Ask yourself this: If Eddie was taking Sears private so he could build Sears exclusively through ESL, would you take advantage of an opportunity to go along with him? It’d be foolish not to, frankly. We have a similar opportunity by investing in their public equity at these prices. Read more from Jeff on SHLD.

Cullen: Another thing you noted was the importance of expanding your circle to include new business areas; can you describe how that process has played out for you so far and any resouces (i.e. books or role models) that helped you create the mindset you have now?

Annello: My circle began as a point on a piece of paper. Now, maybe it’s the size of a Froot Loop, whereas Buffett’s is a Ring of Saturn. Honestly, building your circle of competence is a long and arduous process. It takes curiosity, assiduity, and persistence. I began, like most, with Buffett.

I learned Buffett through his annual reports, partner letters, and speeches, as well as a few books written about him. The book that really set me off was Buffett: The Making of an American Capitalist. That is probably the one book that I’ve enjoyed the most. On top of Buffett, there’s really no substitute for reading the classic works we all know of. I read Buffett, Munger, Fisher, Graham, Greenblatt, Whitman, and Pabrai. Those works consitute 95% of my mental framework.

I’ve read dozens of other investment books, because I enjoy them, but none approach those 7 in quality and personal importance. From there, one needs to begin absorbing history, business stories, economics, accounting, psychology. You need to read about industries, read K’s and Q’s and figure out businesses and opportunities. I read the WSJ, Fortune, Forbes, Barron’s, all kinds of online sources, financial blogs, annual reports, business books. It’s all just a process, a cumulative, slow build. It’s not like one day you know nothing about restaurants and the next you’re a savant. You just need to stay curious and hungry to learn.

The most important thing, in my opinion, is the put your own capital on the line and see what it’s like. You can tell a fish what it’s like to walk on land, but he won’t learn until he does the walkin’. I made so many dumb mistakes in the months after I opened my brokerage account, but I learned more about Rule #1 by losing my money than by reading Phil Town. It forced me to overhaul what I thought and what I was doing, go back and re-read my original muses, and changed my framework for the good forever. I’d read Buffett and Munger but I hadn’t experienced investing until I bought shares of American Home Mortgage and lost it all.

Cullen: I completely agree with you on the importance of putting your own money on the line being the best way to learn. In many ways, those first couple purchases seem like tuition payments to the market; though thankfully the cost doesn’t increase at 7% annually like college tuition… but I digress.
One big learning experience for every investor just starting out is the first bear market or big economic downturn. What in particular would you say you’ve learned in the last 6 months or so that you think will help you prepare better for future cycles? And while American Home had to be a tough outcome, are there any good takeaways from that you can share?

Annello: I’ve learned numerous important lessons in the downturn, even though it is not severe in relation to past market trouble. In fact, I’d say the stock market has held up very well in light of the occurrences in the credit market.

One big thing I’ve learned, through my investment in FMD and my near-investment in Delta Financial, which I’m glad to say I passed on, is that one must be extremely wary of companies that are solely dependent on the capital markets to function. Had the securitization markets not closed, FMD would be worth multiples of my cost basis. That point, however, is irrelevant because the securitization markets did close down, causing extreme duress to the FMD business model. The second point there is that one must also be way of gain on sale accounting. This is something I picked up knowledge in while reading David Einhorn’s book, and through my own investment in FMD. I genuinely believe that FMD used conservative assumptions in booking its gain on sale revenue, but again that ended up irrelevant. I much prefer cash earnings. It creates another layer of safety margin above and beyond buying the business at a discount to value. I’ll never look at companies that use GOS accounting or rely on functioning capital markets the same way again. The market is vulnerable to shocks like the recent one, and I’d much prefer to avoid being exposed to it. There are plenty of wonderful investment opportunities out there without venturing into that territory.

American Home Mortgage was quite a blow to me. I was only a few months into my first foray into real investing when I got hit with that one, but it was no one’s fault but my own, an unforced error.

At the time, I saw a company with a 15% dividend yield that seemed to have avoided many of the problems other lenders had run in to. In retrospect, this was clearly not the case. I did very shallow research and really had no idea what I was getting myself into. The company went kaputz shortly after my investment. I chalk American Home Mortgage up to inexperience and naivety, as well as possible fraud in the case of management. Their statements leading up to the Ch. 11 filing were not consistent with reality, but again I did not do the proper work to discover it, so I blame myself. In that, I learned the value of a deep research process.

I have a new respect for investors who can successful navigate investments in financial institutions. Mark Sellers has pointed out that portfolio managers boast their avoidance of leverage, but own many of these institutions leveraged at 20:1. If you are going with a “look through” approach, then damn if you’re not leveraged!

That’s not to say I’ll avoid financials forever. I don’t want to be like Mark Twain’s cat who got burned on the hot stove and from that point on never sat on the hot stove again, but wouldn’t sit on the cold stove, either. I just have a very different approach to investing after, early on, getting hit hard by AHM and FMD, which were both relatively large positions in my portfolio. While I miss the money, the mentality is invaluable.

See more from Jeff Annello at Circle of Competence.

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Disclosure: James and/or Jeff own shares of some or all of the companies mentioned above.