Wednesday, June 5, 2013

A Man has to Know His Limitations

In the movie Magnum Force, Dirty Harry unravels a series of mysterious murders that look like a gang war. The killers turn out to be a group of vigilante police assassins led by a seemingly by the book bureaucrat. In the scene where Dirty Harry first meets this villain, the outlaw police lieutenant brags that he has never had to use his service revolver in the line of duty.

Dirty Harry’s iconic reply has become a part of movie history, “Well, you're a good man, lieutenant. A good man always knows his limitations.”

Good advice. A man has to know his limitations.

Like Lieutenant Neil Briggs, I too have my limitations. I am always looking for a bargain, a stock that is out of fashion and under valued by the marketplace. Basically, I try to buy stock in companies the same way I buy stereo equipment or any other normal consumer product. I look for the best acceptable product at the lowest cost. I have learned the hard way that I can not be trusted to evaluate technology companies because I have a habit of falling in love with beautiful technology. If you add a low price earnings ratio and what appears to be a sustainable dividend to beautiful technology I am likely to step into something called a value trap.

Definition of 'Value Trap' for new readers from Investopedia:

“A stock that appears to be cheap because the stock has been trading at low multiples of earnings, cash flow or book value for an extended time period. Stock traps attract investors who are looking for a bargain because these stocks are inexpensive. The trap springs when investors buy into the company at low prices and the stock never improves. Trading that occurs at low multiples of earnings, cash flow or book value for long periods of time might indicate that the company or the entire sector is in trouble, and that stock prices may not move higher.”

I bought Cisco Systems (CSC0) after the dotcom bust had run its course. I thought, “The backbone of the Internet! Beautiful technology! Low price earnings ratio! What could possibly go wrong?” It went up. It went down. After a number of years I sold it for a small profit. I also bought shares in Corning (GLW) about the same time. Same story; I still salivate whenever I think about Corning’s technologies. However, their management does not seem capable of tying their shoelaces and chewing gum at the same time. This time I lost a few hundred dollars.

My first serious love affair with a classic value trap was Merck (MRK). They had a wide moat of patents and brilliant researchers around their business. They were considered one of the best managed companies in the world and they had plenty of free cash to pay those dividends. Add in a low price earnings ratio to a historically low price, “Winner! Winner! Chicken dinner!” Nope. I disregarded the fears of an empty pipeline. There were no new blockbuster drugs on the horizon to replace those with expiring patents. I was in love with their existing technology and the quality of their scientific personnel and management. There was a reason the stock was selling at a low price. It wasn’t worth very much. I lost money.

My worst beat down came at the hands of GE. Talk about technology! From jet engines to Magnetic Resonance Imaging machines, they got it. Once again a basic analysis of the fundamentals looked good. What I didn’t know was I wasn’t buying a technological conglomerate. More than one third of the company was a second rate finance company run by irresponsible gamblers. When the subprime crisis hit GE dropped from 35.00 (where I bought my first shares) to 6.00! Ouch! I still believed in GE, because they have good management and beautiful technology. I even bought more on the way down. Trying to catch a falling knife can pay serious rewards, but it is a dangerous pastime. I have just about broken even on GE. This morning I was about $400 down including the cost of dividend reinvestments. I am sad to report I am still in love with their technologies.

Since I now know at least one of my limitations, I stay far away from technology stocks. I have done well with consumer non-cyclicals, utilities, integrated oil, and even some wide moat specialty business like gas and oil pipelines. These are all companies that produce products and services that I understand, but I don’t fall in love with things like gasoline and toilet paper.

By the way, I don’t consider cell phones technology. I consider them consumer discretionary stocks since they seem to be in business of making fashion accessories. It is simply a business I don’t understand. Why is a Motorola Razor the last word in cool for six months? Why is a big screen Samsung cooler than an iPhone, or is it? None of this makes any sense to me, so I stay away from such things.

Please: IF YOU DON’T UNDERSTAND IT, DON’T BUY IT!

Even the great Warren Buffett understands he has his limitations. Here is part of his statement to his shareholders following the US Air debacle.

“If a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot Orville Wright. He would have saved his progeny money. But seriously, the airline business has been extraordinary. It has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in.

You've got huge fixed costs, you've got strong labor unions, and you've got commodity pricing. That is not a great recipe for success. I have an 800 number now that I call if I get the urge to buy an airline stock. I call at 2 in the morning and I say: 'My name is Warren, and I'm an aeroholic.' And then they talk me down.”

Oh, one more thing, Let’s be careful out there today.

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