Friday, March 3, 2023

Four More Big Keys to Your Long-Term Investment Success

By Whitney Tilson (View Archive)

On Wednesday, I shared three important lessons that I've learned from more than two decades on Wall Street...

These are:

  1. Beware of speculating, avoid the hottest sectors, and think independently.
  2. Let your winners run.
  3. Tune out the noise and focus on fundamentals.

And in today's essay, I'd like to share four more lessons you can use to start improving your investment results...

Smart investors focus on free cash flow, not net income...

As an old saying on Wall Street goes, "Net income is an opinion, but cash is a fact."

Net income – the bottom line of the income statement – is the number that investors tend to focus on. How often have you read a headline along the lines of: "XYZ's stock is down today because the company missed earnings expectations"?

Because it's the number investors focus on most, management teams often try their best to "manage" it. Usually, this doesn't entail outright fraud. Rather, net income can be manipulated by rushing products out the door at the end of each quarter (thereby boosting revenue) or reducing assumptions for uncollectable accounts, warranty costs, depreciation, and the like.

But none of these shenanigans influence the cash-flow statement, which simply tracks the actual cash flowing in and out of a business. That's why I always cross-reference both the income and cash-flow statements.

Occasionally, you'll find short-term divergences. For example, a company might be consuming cash to build inventory that will fuel future growth. But in general, the two statements should track each other over time.

If operating cash flow consistently trails net income over time, look out!

A great example is telecom-equipment maker Lucent, whose stock peaked in 1999 at $84 a share, giving it a $258 billion market cap. It was one of the most widely held stocks in America.

The company had beaten analysts' estimates for 14 consecutive quarters through the third quarter of 1999. It was booking big sales and profits when it shipped its products, reporting $3.8 billion of net income in the first three quarters of 1999 versus just $815 million in the same period in 1998.

But the cash-flow statement told another story... Cash flow from operations was minus $1.3 billion in the first three quarters of 1999 versus plus $1.6 billion the previous year, a negative swing of $2.9 billion!

It turns out that Lucent was selling to many dicey startup companies that were increasingly having difficulty raising capital. And without new cash, they couldn't pay for the equipment Lucent had delivered to them...

Savvy investors who paid attention to the cash-flow statement and got out saved themselves from a bloodbath. The stock collapsed to around $2 a share.

Rule No. 5 is to be wary of companies that are constantly making acquisitions...

Various studies have shown that 70% to 90% of acquisitions fail.

It's not hard to see why. Sellers have perfect information and generally only opt to sell when the company and/or industry is at a peak and valuation multiples are highest. And buyers tend to have an overinflated sense of their management abilities and are often motivated by empire-building or other noneconomic factors.

Plus, hiccups (or worse) are common when integrating two companies, which may have different cultures and systems. Lastly, it's easy to play games with the numbers when acquisitions occur, greatly increasing the chances of accounting fraud.

For all of these reasons, it's generally best to view highly acquisitive companies with a skeptical eye.

That said, this isn't a hard-and-fast rule because there are a few notable exceptions...

For example, Warren Buffett's Berkshire Hathaway (BRK-B) has made dozens of acquisitions over the years, nearly all of which have worked out beautifully. In fact, Berkshire's acquisition of National Indemnity back in the 1960s provided the entire foundation for Buffett's $500 billion empire.

We've also seen brilliant acquisitions from tech giant Alphabet (GOOGL), which bought video-streaming platform YouTube in 2006 for $1.7 billion... and Facebook parent Meta Platforms (META), which purchased Instagram in 2012 for $1 billion. Both of those acquisitions have added tremendous value to their respective companies over the years.

In summary, be careful! When it comes to acquisitions, history has shown that more things go wrong than right.

Rule No. 6 may surprise folks familiar with my work: Avoid shorting, but respect short sellers...

During my nearly two decades of managing money, my primary focus was on buying and holding undervalued stocks. But I also shorted hundreds of stocks over the years.

Shorting is a brutally difficult endeavor. Overall, I lost a lot of money doing it. So my advice to nearly all investors is simple: Don't do it! It's too hard and too risky.

That said, you'd be well-served to learn about what short sellers look for. It will help you avoid "value traps" – stocks that appear attractive, but end up going nowhere (or worse, down a lot).

To survive, short sellers have to be very smart and do outstanding in-depth research – far more so than traditional long-only investors. Thus, if you're considering buying a stock with a high short interest, stop and do even more research.

Here's a good rule of thumb: Any time you plan to go long a stock with a short interest of more than 5% of the shares outstanding, watch out. It means that a lot of sharp investors are betting against you, and you need to figure out what they're seeing.

Sometimes, the short thesis is obvious, as more and more short sellers are putting their work out there publicly by releasing reports, publishing articles, and speaking at conferences. Other times, you have to do some digging. The vast majority of short sellers never reveal what they're doing or why.

Though I'm cautious of companies with a high short interest, there are occasional exceptions. In fact, some of my best long ideas have come from stocks that are popular among the shorts because it reflects extreme negativity toward a stock.

A good example of this is my trade on Netflix (NFLX). The stock had fallen by more than 80% and was trading at a split-adjusted $7.78 per share on October 1, 2012. That day, the short interest was a staggering 30%.

But I wasn't dissuaded. I knew who was betting against it (and why)... and I was convinced they were wrong. So I pitched it at my investing conference... wrote about it... and appeared on CNBC telling folks it was going to be the next Amazon (AMZN).

The company's market cap has since gone from $3 billion to around $140 billion, and it has been a popular short the entire way up. It has likely cost the short sellers billions of dollars – yet there's still a 2% short interest!

I'd urge you to have tremendous respect for short sellers. Any who have survived the historic bull market had to have been good. They were swimming upstream against a powerful current for a decade!

My last bit of advice when it comes to investing is to keep things simple...

The best investment ideas can usually be explained in writing in one page or verbally in a couple of minutes. And their success is usually dependent on a few factors – sometimes only one – that need to be analyzed and evaluated.

But it's easy to forget this with the Internet at your fingertips and round-the-clock coverage of the markets. Investors are being bombarded with so much information that it can be almost impossible to separate the signal from the noise.

Doing so is critical to long-term investment success... which is what I aim to help Empire Financial Research subscribers do.

And as part of my mission to help readers, you'll want to hear the details about the massive opportunity I've recently uncovered...

It's something I've been calling the "1,000% Windfall."

I flew all the way to Texas to see the opportunity firsthand... and I hired a full film crew to create a video of this exclusive "on location" investigation.

This could be the investing story of the next 12 months – don't miss out. Before it goes offline on Monday at midnight, watch our special investigation – and learn what to do to position yourself for big gains as the whole thing plays out – right here.

Best regards,

Whitney Tilson
March 3, 2023