Book Review — Common Stocks and Common Sense

Investing can perhaps be best learned through a combination of applied practice and continuous study. While there is no substitute for real-world experience and the valuable lessons learned from making and losing money, reflecting on the wisdom of those who have gone before us can also provide insights, and build useful practical knowledge. By paying attention to the counsel of successful investors that is contained in their books, we can refine our own skills and investment styles.

There are many kinds of investment books, from the qualitative to the quantitative and fundamentals-driven, and everything in between. Ed Wachenheim, who runs Greenhaven Associates, strikes a nice balance between the two in his new book, “Common Stocks and Common Sense: The Strategies, Analyses, Decisions, and Emotions of a Particularly Successful Value Investor.”

• Edgar Wachenheim III
• The book can be found here.
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Ed uses a series of 11 instructive investment case studies, involving real-life examples from his successful advisory business, to reveal elements of his own style of value investing: Buy cheap, identify positive catalysts, invest with a margin of safety, be a contrarian, and control your emotions.

While every student of value investing is familiar with these rules of thumb, it is Ed’s discussion of the details from his own experience that makes this book a unique and enjoyable read.

Using the case studies to provide context, Ed walks the reader through his rigorous analytical and decision-making process.  Each investment contains a core insight that becomes a template for readers to use when considering their own investment opportunities.

Ed urges us to think independently, and demonstrates the value of creating a unique frame of reference that is sometimes at odds with conventional thinking. This creates opportunity.

What I like about the book?

Warren Buffett says we should stay in our “circle of competence,” and focus only on the areas we truly understand. As Buffett’s partner, Charlie Munger, put it:

If you want to be the best tennis player in the world, you may start out trying and soon find out that it’s hopeless…However, if you want to become the best plumbing contractor in Bemidji, that is probably doable…

It is the wise man who knows what he doesn’t know. Ed would probably make a great plumbing contractor in Bemidji, since he knows how to stick to his circle of competence. He avoids making predictions on things like interest rates, the economy, and commodity prices.  He avoids stocks with high multiples. He doesn’t short, and he doesn’t hedge with options. Instead, Ed carefully defines his own circle of competence in investing: Selecting value stocks that offer enhanced returns.

It’s the details of his review of certain stocks that provide the most compelling insights: You can make money when expectations do not reflect reality; sometimes companies are priced as if they have long-term problems, even though these problems can be fixed; successfully predicting a change in fundamentals can be profitable.

There were several cases in which high returns were possible due to structural industry changes. For instance, Ed correctly anticipated the upturn that occurred in the housing market after 2011, which had a significant effect on shares of Lowe’s Corporation.

Ed also did not shy away from his failures. He discussed a “value trap” experience, when shares in U.S. Home Corporation stubbornly continued to trade at a depressed multiple for many years. He described a painful loss he experienced investing in AIG. He described making the same mistake twice: He sold a profitable position in IBM at $16, only to watch the shares climb to $24; from there he rebuilt his position, and sold again at $48. Next he watched shares go to $80. “It is impossible to do everything right…I try not to fret over mistakes,” he says.

I was especially interested to see that Ed included some interesting material about behavioral finance, which he seemed to grasp intuitively:

I believe that the efficient market hypothesis fails because it ignores human nature, particularly the nature of most individuals to be followers, not leaders. As followers, humans are prone to embrace that which already has been faring well and to shun that which recently has been faring poorly. Of course, the act of buying into what already is doing well and shunning what is doing poorly serves to perpetuate a trend. Other trend followers then uncritically join the trend, causing the trend to feed on itself and causing excesses.

This neatly describes the behavioral effects attributed to the two strongest stock market anomalies, value and momentum.

There was also a nice summary chapter of Ed’s overall approach to investing, which included 25 pieces of wisdom that read like a Howard Marks Memo.

Constructive Criticism

I sometimes found it to be a challenge to draw general conclusions based on the case studies. For example, Ed described his investment in Interstate Bakeries as being heavily influenced by his belief in the competence of the CEO. As process-driven investors who are painfully aware of behavioral issues, this struck me as dangerous territory. I think it can be a stretch to infer cause and effect when it comes to inherently subjective and non-scientific opinions about management. James Simons summarizes the issue nicely:

“How were you feeling when you got out of bed thirteen years ago, when you’re looking at historical simulations? Did you like what the model said, or did you not like what the model said? It’s a hard thing to back-test.”

–Jim Simons, CEO, Renaissance Technologies, LLC

While I was expecting the book to focus on investing, at times it had a memoir-like feel. We hear about Ed’s early professional experiences, and get a description of a “day in the life,” complete with conference calls, work at the Bloomberg terminal, and lunch at the club. Frankly, while this background information is interesting, I would have preferred hearing more about the operational turnarounds and valuation discussions, which are quite interesting and insightful.

Summary

Notwithstanding a few critiques, this is a solid book for all fundamental investors focused on stock-picking. The book also provides good insight for systematic and quant investors, because it gives a clear glimpse into the mind of the classic stock-picker. Ed provides his take on numerous investing topics, such as diversification (e.g., concentration is ok), volatility (e.g., quite harmless), leverage (e.g., avoid it due to bankruptcy risk), and many other areas.

But the case studies are the real core of the book. I found it fascinating to hear how a long-time professional goes about picking an investment. Ed takes us through the industry dynamics and the clear and simple logic he uses in creating earnings estimates and calculating a firm’s intrinsic value.
Having spent more time than I would care to admit fooling with financial models and fundamental investing, I can say that often the biggest risk is that instead of being generally right, you can wind up being precisely wrong. You may have all the working capital items, deferred taxes and depreciation schedules just right, but if you miss the big picture, such as an important industry trend, you are going to be way off.

Perhaps this is why sell-side analysts are often wrong. They are all CFAs. They are all accounting experts. But they go into a valuation exercise with a predetermined view (since it must be in line with consensus), and then reverse engineer their model to fit this view, while obsessing over unimportant details to fine tune their EPS figures. Meanwhile, Ed ignores the consensus, and doesn’t sweat the details, but focuses on the big muscle movements of value. For instance, he explains how in the late 90s, the S&L crisis had destroyed lending to small builders, and so all their business went to the big public homebuilders. Seeing this big picture dynamic, Ed bought the most promising public homebuilder, which then enjoyed double-barreled effects of increasing revenues and operating leverage that the street had entirely missed.

Ed makes it sound so easy, which is reminiscent of the stories told by Warren Buffett. But of course, a mantra we often highlight is that value investing is simple, but not easy.