Diary of a Stockpicker

Debashis Basu 23 December 2016

Edgar (Ed) Wachenheim, chairman and chief portfolio manager, Greenhaven Associates, has written an unusual book. Common Stocks and Common Sense: The Strategies, Analyses, Decisions, and Emotions of a Particularly Successful Value Investor is a series of investment case studies on specific stocks, picked from his many years of managing money. The case studies showcase his process, from start to finish. How he initially gets interested in a stock, gets into analysing it in depth, follows it through by meetings with the management and, all the while, is mindful of the margin of safety and controlling emotions.

Investing is an art, which one continuously improves upon, while trying to make fewer errors as the years go by. One way to reduce the errors and hasten the learning process is to benefit from the experience of those who have gone through the process of making, and losing, money and are willing to share it with us through books. There are many books that are autobiographical in nature such as No Bull by Michael Stienhardt. Their contribution to knowledge about the life and times of successful investors is invaluable. But there is hardly any book that showcases how big investors follow a step-by-step process of selecting stocks, tracking them and exiting from them. Wachenheim has written exactly such a book.

There is a wonderful passage where both, Ed and Stienhardt, were interested in IBM but for different reasons. IBM had a very profitable and fast-growing subsidiary in Japan. Stienhardt calculated that the combined market value of the two IBMs (IBM Japan and IBM ex-Japan) would be far in excess of IBM’s existing share price. He wanted IBM to spin off its Japanese subsidiary to IBM shareholders. Ed doubted the practicability of dividing IBM into two companies. Instead, he wanted to know why IBM was not reducing overheads more aggressively.

Both of them got an appointment to meet John Akers, the CEO of IBM. When they met Akers, “one minute Mike was asking about Japan, and the next minute I was asking about costs,” writes Ed. “Then, Mike had another thought about spinning out Japan, and then I had a thought about weeding out the dead-wood as opposed to incentivising the most capable to leave IBM. It went back and forth for a full hour. Akers could not have been more courteous, but it was clear to me that he was not going to cut costs more aggressively—and it was very clear to me that he was not going to spin out Japan.”

In early 1993, Akers resigned and Lou Gerstner became the CEO. Gerstner announced that he was going to take tough steps. Ed decided to seriously consider making a large investment in IBM’s shares, based on his estimate that Gerstner might be able to reduce costs by $5 billion which, after taxes, would add about $3.4 billion to net earnings, or about $1.50 per share based on the 2.29 billion IBM shares that were outstanding. He further estimated that the company’s revenues would grow at 5% and, therefore, that IBM’s earnings power, in 1995, could be about $1.65 per share.

“When we purchase a stock, we are interested in what the company will be worth two or three years hence, so the $1.65 was an important number,” based on two different methodologies. Finally, he valued IBM at 12 to 13 times earnings; thus estimating that, in 1995, the shares would be worth $20 to $21. IBM’s shares were selling at $12. Ed’s firm purchased a substantial position in the shares at an average cost of about $11½ in mid-1993.

How did it pan out? Soon, Lou Gerstner announced a plan to cut payroll. “In November, IBM’s shares started to appreciate. By August 1994, the shares were selling at about $15½. By that time, the common wisdom on Wall Street was that Gerstner’s cost-reduction program had been successful. It appeared that the company would earn about $1.25 per share in 1994 and materially more in 1995… I decided to sell our position, which we accomplished over the next few months at an average price of just above $16. We earned a 40 percent profit in the stock. Yes, I had estimated that the shares might be worth $20 to $21 in 1995, but a bird in the hand is worth two in the bush—and I was happy to realize the 40 percent profit.”

This was a mistake. But you need to read the book to know why. The reader is offered a ringside view of 11 such investment case studies, including some failed ones. The book ends with Ed’s 25-point approach to investing. Certainly worth reading.

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