The other is reason is I think that it should be based on what you’re saving your money for in the long term, too. So, it’s not only about risk tolerance, but are you saving for retirement? Are you saving for a vacation? Are you saving for a house? Are you saving for a charity? There are different goals that people put money to work for.

I think that there is no one flavor nor one size that fits all for different people. You have to account for the risk tolerances, the industries they’re comfortable with, and the ultimate goal they have, whatever it might be. In years past, Robert, investing was kind of an afterthought. You had companies that were going to give you a pension, so you didn’t have to worry about retirement, and then you had a 401-K, some fund that you don’t really know what’s in it nor how it goes, but you just put money into. I think that, nowadays, it’s more and more important to be actively involved in knowing, even at the company level, where your money’s going, and how well it’s doing, tracking it down over time. And so, to me, it really is a very personal thing.

Robert Leonard  04:04

We’ll talk about this later in the show, but one of the things that you mentioned is the decline that your stocks can go through. That’s a very personal thing, and we’re experiencing that right now for probably the first time for a lot of people that are listening to the show. A lot of people that have been investing, even for the last decade, and a lot of people that are listening to the show, fit into that category, and it’s pretty much just been a straight line up.

It’s been a great bull market, and so, they don’t really know anything about it going down. We might say, personally, that we can experience a 30% withdrawal or downgrade in our account, and that’s not going to hurt us emotionally or psychologically. And then if it actually happens, now is the first time we’ll be able to really experience that. So, I think I agree exactly with what you’re saying about investing being personal.

You also have a principle that says, “You’re buying companies, not tickers.” In my anecdotal experience, I’ve seen this to be a big disconnect for a lot of new investors. Why do you think that is? And what does it mean to buy companies, not tickers?

Simon Erickson  05:01

So much of what we’re seeing are stock prices tied to financial results; quarterly earnings, earnings per share. Did they beat earnings? Did they miss earnings? That’s the discussion that we’ve gotten used to hearing, but really, I think of financial results as being the exhaust of the car based on how the driver’s driving the car. If you’re behind a giant bus and you see this giant plume of black smoke hitting your windshield, it’s probably because the driver of the bus is slamming on the accelerator right now. But maybe the bus isn’t equipped to be slamming on the gas or something like that. Financial results are an impact of business decisions that are still being made by management teams.

To the point of companies are still what we’re investing in, and not tickers, it all goes back to the stock prices based upon financial results. Financial results are made based upon business decisions that are being made by management teams. We try to peel back to that third or fourth layer when we’re analyzing companies, where we’re not just looking at earnings per share, we’re not just looking at whether the stock is up or down 5% or 10% in the last quarter. We’re looking, fundamentally, over who’s driving the bus. Are they making the right decisions? And where are they investing in their future? Because three to five years out, that’s going to be a lot more important than how the stock did these last couple of months.

Robert Leonard  06:15

Also, you’re actually owning a piece of that business. That’s why those business results are so important. You’re not just trading a ticker or a blimp on a screen, which I think a lot of new investors think. That’s just not the case. The case is that you’re actually, albeit relatively small, you still have a small ownership stake in that business. That’s why it’s not just a ticker on a screen. I think that’s great advice.

Now, another principle of yours is “time is on your side.” I think that’s a very relevant one for the audience listening to the show today, given that the show is called Millennial Investing, and that the majority of the audience falls between probably 22 and 35 years old, maybe even 40 years old. Why is this one of your principles? And why is it so important?

Simon Erickson  06:56

Well, if the people listening to me on this podcast is to only remember one thing and forget the rest of this interview even exists, the one thing I would encourage you to think about is to start as early as you can in investing, and for the longest period of time. Because good companies are compounding machines. What I mean by that is if you’ve got cash sitting in the bank, but you’ve got a business that can use that cash to do something that’s going to produce more than the current value of what that cash is right now, you should go out there and do that. And then all of a sudden, you’ve compounded that money and created excess value, which then you can share with your shareholders. The longer that you can think in terms of letting those businesses and those stocks compound for you is just a huge, huge advantage.

There’s another aspect to this question, too, of time being on your side. Everyone is trying to play the short term game right now. Day trading is a bad word in the investing world, at least for the long-term investors like we are, because it’s very hard to beat those. You have so much algorithmic trading taking place right now. You have every single trade being monitored out there by high-frequency traders. There are software that can monitor everything. This is very, very hard for individuals to compete against, unless you want to spend a ton of money to try to get on the same level as those guys.

But there’s really no software program, at least that I’m aware of right now, that can qualitatively look at decisions being made by a business manager, or can assess if they are investing in the right things for R&D for the future. What is this business going to look like three or five years out, versus just who’s trading hands for the stock right now? And so, the real advantage that we have as individual investors, I think, is to think in longer terms. Because over time, even if stocks are out of favor for the time being, if you still have good businesses, that goes back to compounding over time. You’ll be coming out ahead in three to five years, which is a field that nobody else is playing in right now.

Robert Leonard  08:50

I believe it was Albert Einstein that once said, “Compound interest is the eighth wonder of the world.” He didn’t say that for no reason. Compounding can’t work for you if you don’t have your money in the market and you don’t give it time. So when you’re the age of the people listening to the show, and you and I, Simon, time is on our side, as long as you let time do its thing. What that means is you need to have your time in the market, have it invested, and let it compound for you.

You have a few more investing principles, but the last one that I want to talk about is “valuation matters.” In my opinion, we had seen over the last few years, a lot of investors forgetting about valuation, or just not putting much weight on it. But I think a lot of people in the audience are value investors and follow the teachings of Warren Buffett, so they’ll enjoy this talk about valuation. I know I will, as well. I know you’re a growth guy, so knowing that this is one of your principles was interesting to me. Why is valuation important? And how do you decide when a business is so great that it actually deserves a bit of a premium?

Simon Erickson  09:49

There are basically three ways you can make money in the stock market. The first is fundamental improvement. The business reports higher earnings per share over time. As the business grows, the stock grows. The second is just straight up dividends. Companies can pay out dividends from their cash or from the earnings that they create. And then, the third one is valuation that investors are willing to give any particular stock.

It’s a continuum. We’ve kind of created adjectives to make sense of it and categorize it; like a value stock like Walmart or something that is not trading at a high multiple of earnings, or growth stock like Facebook where people are willing to pay a little bit more because the business is growing faster. But, at the end of the day, it’s all a relative way to understand the expectations built into the company.

Valuation matters because you try to look for things where there’s a disconnect, either on the value side or the growth side of that continuum, that just don’t look quite right. If we see an evaluation for Walmart, based on the stock price of today, that they’re expecting the stock price or the company to grow at 40% a year, you’d say, “Wait a minute. No, that’s completely out of line. Walmart’s supposed to grow with GDP. It’s a retailer.” On the other hand, if you’ve got a “growth” company that’s been growing at 60-70% a year, and people are saying the expectations are for 20% growth, even though that’s a premium for a company like Walmart, it still seems like it’s out of whack.

And so, when we say that valuation matters, we don’t mean we’ll just just buy undervalued companies or “value companies”. We just really mean “what are the expectations that are baked in to any current stock price?” And look for the disconnects because there’s a lot of them, in my opinion, Robert, especially on the growth side of that, as you mentioned. For companies that are really doing things differently, that are really innovative, and doing some cool things, it’s hard to value them because they don’t grow up and go up in a straight line. 

For Chipotle, we can kind of figure out how much sales it’s going to do next year versus this year. For Walmart, we can probably figure out based on past transactions. For companies that are doing stuff in quantum computing or cloud computing or biotechnology, it is very hard to model because all of a sudden, something really neat can happen and it just shoots up like an S-curve or have a hyperbolic growth rate.

And so, for me, the most interesting companies to invest in, again, as a self-described growth investor, are those companies that I don’t think are being modeled in a way that reflects what’s really happening. You have to dig a little bit deeper. They’re a little bit harder to understand, but the payout can be incredible if you find a couple of those in your portfolio.

Robert Leonard  12:31

What you just said there highlighted two things that I want to dive a little deeper in. The first thing was you mentioned Walmart as an example. You mentioned that, based on the current price, you can extrapolate an expected growth rate for that company, or what the market is expecting the company to grow at. Dive into that a little bit for us. How can the price of a company illustrate what the market might be expecting for growth?

Simon Erickson  12:58

There are a couple different ways to do this. The fundamental way of doing investing analysis is based upon a discounted cash flow model. If you talk to people that are really in the weeds, they’re building out models of future growth rates for a company. After a company pays all of its operating costs, material costs, salaries, capital expenditures, anything that it needs to run the business, it still has cash leftover at the end. That’s free cash flow, and we can discount that back, depending on whatever discount rate we want to use to the present. That’s the value of what these shares would be fairly valued at.

One way to do it is to just build out a model for every company in the stock market. It takes a lot of work. It’s really hard to do, involving a lot of input and unknowns. But for companies that are easily moddable, like the Walmarts and the AAA’s, that’s a really good way to value them.

The other completely different way of valuing companies is to think in terms of market share and the addressable market that they’re serving. You can look at things like multiples, price to sales, price to gross margin, price to cash flow, price to earnings, or whatever your flavor might be, and try see “is this company being valued in a way that makes sense of how fast they’re growing into their market?” To do that, you can also kind of assess, “What is that market? Are they really making progress? Or is there just a lot of hype that isn’t really going to come true?”

It’s kind of one-part science, where you can really be quantitative about everything, and one part art, where you can really be qualitative, and kind of blend the two of those together. It’s not an exact science. And it’s very, very difficult, especially when there are very complex inputs that can have a lot of variants, but they can also be extremely rewarding because that’s where you see these mispricings in the market.

An actual example of that is Tesla. I have seen a price target for Tesla. It said it was worth $10 a share in the worst-case scenario, and I have seen a price target for Tesla that says it’s worth $7,000 a share. These figures were given by professional investors. To have that kind of variance out there, it could be anywhere in between either of those inputs, going well or badly, for the company. At the end of the day, you’re still taking risks in the market. But we do tend to find the disconnects where it seems like it’s out of whack with reality.

Robert Leonard  15:10

The reality with Tesla is that it’s probably somewhere in between those two, although some would argue it’s also zero. So, that could be a possibility, but.

Simon Erickson  15:18

I’m willing to say it’s between $10 and $7,000. I’ll go on record, and say it’s worth somewhere between those.

Robert Leonard  15:24

Although I’m no expert on Tesla, by any means, I would probably bet in that range, as well.

Let’s tie all of this together, all your investing principles, and your overall strategy. I want to talk about, specifically, how you analyze individual companies. Let’s assume that you have some cash on the sidelines that you’re ready to invest with. You have no watchlist setup or any ideas that you’re already interested in. Where do you start? What is the first step you take when looking for potential investments?

Simon Erickson  15:56

There are a hundred different ways to answer that question. Again, that goes back to the different styles of investing. But for me, personally, I’ve always been a guy that’s gone out and gone to conferences, talked with people that are a heck of a lot smarter than I am, and try to figure out what’s going on in the market because there’s really some big, big changes taking place. From there, after I kind of understand those changes, I say, okay, where’s the money going to be? Which companies are going to take advantage of that and capitalize? Are they making the right decisions? Do they have a good management team? All that stuff is important too, but at the end of the day, you want to look for markets that are growing, that can afford to grow, and are willing to take on smaller companies that are able to take part of that share.

I kind of start at a higher level. Where are the biggest changes taking place? I see some big changes taking place in medicine. Healthcare, right now, is becoming much more objective because people are looking at data versus just subjectively treating symptoms and conditions. We’re seeing genomics getting right down to the DNA level of how we’re built as human beings to treat conditions way in advance and proactively. I see a huge market in content that’s being delivered not just in the structured and bundle Cable subscriptions anymore. We’re now splitting that up into streaming. What is that going to mean now that everybody’s got Hulu, Cheddar, their Fox app, and whatever else it is you can watch a la carte, rather than paying a set amount for the cable bill every month. I think that’s going to be a huge trend.

Cloud computing, artificial intelligence, biotechnology. Stuff like these are just changing everything that we knew. They’re sometimes $50-billion, and sometimes $100-billion markets. Value finds a way to emerge over time, and the innovators out there, the companies that are doing things differently, have a lot to gain if they’re in the right market with the right solutions. And so, I always start at the top, and see what’s going on in the market.

Robert Leonard  17:40

You start with the industry or a trend or something along those lines, and then you drill down into that, and find specific companies. Once you’ve identified the trend or the industry that you’re interested in, how do you find those specific companies?

Simon Erickson  17:55

We can talk about the first example I gave, which was medicine. Right now, there is an ability to diagnose cancer, it’s basically based on a tumor that they find. If a patient is showing symptoms, they come in, and notice there’s a cancerous tumor, often in Stage 3 or Stage 4. It’s very, very serious. There’s a much lower life expectancy when you catch it that late. But there’s also a lot of work being done right now.  There’s a market change. There’s a lot of innovation right now. What if you can detect those tumors much, much earlier? And instead of detecting it directly from a biopsy of the tumor itself, you can detect it in the bloodstream?

There’s something called circulating tumor DNA. There are small fragments of a tumor’s DNA that are floating around through the bloodstream. Through a simple blood test, you could catch something like that in Stage 1 or super early, instead of Stage 3 or Stage 4. Life expectancies would go up significantly, hospital costs would go down significantly, and you would have healthier patients and a lower cost healthcare system because you’re able to have much improved diagnostics.

Researching led me to a company called Guardant Health, which is one that I’ve recommended in the past. I’m still a huge fan of it right now. They are basically developing a test that is catching the circulating tumor DNA of cancer. Right now, they’re focusing still on late stage. But if you could proactively take a test for everybody that’s over 55 years old or 65 years old, and catch this stuff proactively, that’s a huge win for a lot of people.

And so, that’s something that I discovered, to answer your question. You look at the bigger picture. What’s the problem here? How can we solve it? Who’s the right company that’s doing that? There are other stuff, too. You want to look and make sure that your CEO and your management team are doing the right things, making the right decisions. Insurance is also a really big factor for healthcare-related stuff. But it starts at the top. What’s the problem? And who’s the company that’s solving that?

Robert Leonard  19:46

I know we just talked about valuation a few minutes ago, but because of this example, I want to go back to that for a second. When you talk about this idea, I can understand the massive implications that could have, the value that could create, and the potential value for the stock. If all of that comes to fruition, how do you even go about valuing something like that?

Simon Erickson  20:08

Something like that right now is largely out of pocket. It could cost a couple thousand dollars to have one of those diagnostic tests done. But what if your insurance carrier picks that up? What if all of a sudden, Medicare is setup? All of a sudden you’re talking zero cost. You’re not just talking about a 5x increase right there. You’re talking about 100x or maybe 1000x increase. That’s one example of the exponential growth that we were talking about. An event like that would really have an implication.

It’s the same with biotechnology. Look at drugs. We’ve got a lot of early-stage biotech companies right now. There’s a lot of really neat and cool stuff going on with life sciences, too. CRISPR is allowing for gene editing. Maybe some of the audience has heard about some of this stuff. *inaudible* is another way where we can edit parts of the genome to make drugs that are more personally fit for certain patients. Things like this, again, are very hard to model with current valuations because you’re either betting it’s going to work or it’s not going to work. It’s very hard to have a middle ground. Is the drug going to get approved or not? You can build decision trees and things like that, but if it works, and if this succeeds, that’s a huge win for the valuation. That’s why you see these pops. It’s not as dramatic as biotech everywhere out there, but there is a lot of that in technology where you have small companies that get a hit with some big companies real quickly.

Software as a service is something that we’ve been talking about quite a bit lately because there’s very low startup costs other than R&D and acquisition of new customers. Building things in the cloud is much less expensive than it used to be to develop software. All of a sudden, you have 90% gross margins, get some big customers on board that are adding thousands of seats at large corporations, and boom, you’re set. You’re a small company that gets a big win with a really big corporation, and now every other corporation that’s a competitor wants to do what the company is doing. You can see things like that become what we’ve called multi-baggers. They’re worth 100% or more of their current value in a very short period of time. Put a couple of those in a portfolio that can forgive a lot of other bets that you’re making in growth-style investing, and the math still works out. You’re making really good money over the long term.

Robert Leonard  22:22

This whole piece of the conversation brings me back to what we talked about earlier of it being personal. Someone who’s taking this type of approach and making bets on these types of companies needs to understand how they think about this and how they’ll feel if that company goes to zero, while another company that they bet on went 2x or 3x. They need to understand if they’re emotionally okay with that, if that’s the strategy that fits them well.

I just wanted to mention that because this is a strategy that can definitely work if it’s right for you, but it has to be right for you. For me, it’s not necessarily right. I’m more of a value guy, but I know a lot of people have done very well with it. I think it is a good strategy for a lot of people. I don’t think there’s anything wrong with the strategy itself. It’s again, just personal. You need to make sure that it aligns with you.

Simon Erickson  23:02

A caution. Growth style investing can be exciting, right? You’re looking at some cutting-edge stuff. Everyone wants to see where the future is going. It’s really fun to talk about. But there are some pitfalls for it, too, that I do want to caution people about. For every Netflix or every Amazon, for every company out there that’s really been a big winner in the stock market, there are a lot that don’t work out too. And so just investing in a company because you see headlines about it, or you’re excited about the future, isn’t the right way to think about it. Yes, it means higher reward, but it also means higher chance of not being rewarding, too.

You can have companies go bankrupt if their child doesn’t take off. In biotech, you can have companies that spend all their money on developing a software and then nobody wants to buy it because it just didn’t go in the right time, etc. And so, back to investing being personal, we never encourage anybody to go all-in on any one company. You have to balance that and make small bets. You can also add over time. There’s plenty of time, and investments a long-term game. It’s a years-long, decades-long game. Don’t feel the rush or the fear of missing out to just go put all of your money on the greatest new pot stock you heard about from your uncle last week. There’s nothing wrong with taking high-risk bets, but there are also pitfalls. I would caution against getting too excited without really seeing a long-term progress from the company you’re investing in.

Robert Leonard  24:24

We’ve identified some trends and some industries first, and then we decided that we look into specific companies in those trends. So now, we have a list of companies that we’re interested in. Where do we go from here? Do you dive into the company’s 10-Ks? Do you look at their financial statements? Do you look at their annual report? Do you look into the management team?

Simon Erickson  24:44

Yes to all of the above. Those are all excellent things for investors to do. I would encourage everything that you just mentioned. Definitely look through the 10-K, the annual report, and also look at the proxy. Every year a company puts out a proxy, which explains who owns the company, who owns what percent of shares of that company, and how the management team is getting paid.

Every publicly-traded company has an executive compensation plan that’s been approved by shareholders. It explains what metrics they need to hit to get paid on certain things. We want to see companies that are not only growing the top line and sales, but also growing the bottom line. Profits, or even better cash flows, or even better return on invested capital, you want to see something that’s accruing for the good of investors, rather than just growing at the top line.

Another thing that I spend a lot of time thinking about, which I think is unique out there, is the R&D line item on the income statement. That’s reported also in the in the annual report and in updates every quarter, too.

Basically, how is the company spending its money? And why are they doing that? Are they doing that just to keep steady as she goes, keeping the same business that they’re doing? Or is it somebody like Elon Musk with Tesla who’s plowing money into building a Gigafactory in China right now because he’s so convinced that his Teslas are going to sell in China. On top of that, he’s plowing money into autonomous driving because he’s so convinced that the full self-driving mode for his vehicles is going to be a huge competitive advantage versus the other companies. Think what you want of Tesla. Some people are very bearish. Some people are very bullish. Some people think Elon Musk is brilliant. Other people don’t. They have a different adjective to describe him.

But do think about those kinds of things. Tesla could just look like the same car company it is today, where it’s turning out 400,000 vehicles a year. It’s got the Model 3. It could be banking all of that money that it’s making, but it’s not. Elon is plowing that aggressively into new ventures, and the art part of investing is figuring out what does that mean? Is that going to be worth it? Or is he lighting money on fire and we’re all going to lose a lot of money from this? Disclosure, I am a Tesla shareholder. I have faith in a lot of those activities that he’s doing, but with stuff like that, you have to really look because so much of investing is in the future.

Robert Leonard  27:00

Once we’ve found those companies and we’ve dove into those different reports, we probably have a dozen, couple dozen, maybe even hundred or so different companies. Where do you specifically look first to try to eliminate some companies right off the bat? Because in reality, with all of those different companies to analyze, people just don’t have enough time for that unless they’re a full-time investor. And even then, they might not have time. So, where do you look first after you’ve identified the trend in the industry and have a list of companies? Where do you look first to eliminate the companies right off the bat, so you could dive into the ones that are more promising?

Simon Erickson  27:35

The first deal-breaker is just a management team that you don’t have faith in. Even if you’ve got a great trend, a great market, a lot of money at stake, if you can’t trust the management to make the right decisions, that’s a deal-breaker. You want to look for a management team that has successfully led a company in the past or at least has relative experience that’s directly applicable. There are a lot of companies out there that are in the right place at the right time, and they’re never going to make any shareholder value for you. So it can go both ways. Even if you have a great market, if you don’t have a great management team, you’re not taking full advantage of that.

The second is something I would encourage all investors to do, which is to come up with specific metrics that are very important for that company. The more specific, and company-specific, the better. It doesn’t have to be revenue growth or earnings growth or other data that institutions tend to get overly-obsessed with.

For Tesla, it could be the error rate of their self-driving cars. Are they significantly safer in terms of errors per thousand miles driven or so? Are they safer than the other cars that are being developed? That could win over the regulators, allowing the self-driven cars in other places, and more production that will lead to more purchases. Or China? Are they selling the cars in China? Is the Gigafactory paying off? Have a metric that’s Tesla-specific that you could see would be very important. Then, you can start getting a feel for whether these companies are performing where it matters. If you can answer those questions, you’ll be ahead of 98% of the investing world out there because you’re thinking at a higher level about what really matters for the company to produce meaningful cash flows for its shareholders.

And, if you are dissecting the company’s annual report, quarterly results, and all of the things that we talked about before, it will really give you a huge advantage, especially if you’re investing for the long term.

Robert Leonard  29:20

That reminds me of a book I once read, called Measure What Matters. It’s all about developing KPIs for your business, and really measuring what matters for that specific business, and not worrying about different metrics, different KPIs that matter for other businesses. If it doesn’t matter for your business, then you don’t need to focus on it. It’s the same for what you just said. Look at the business that you’re considering analyzing, make your own KPIs, and then track those and see how the business is doing. What’s great about that is you can unlock a lot of value there. You could notice something in your KPIs that maybe someone else doesn’t.

A lot of people are valuing companies or analyzing companies based on traditional metrics, like you mentioned, that Wall Street is obsessed with. If you can find the right KPIs to analyze a company, that might be a little bit under the radar but really is a key indicator as to how that company is going to perform, you can unlock a lot of value. This point is so true. I think, if you really focus on the KPIs, that’s what matters. People are always focused on earnings per share, but your point about Tesla, I definitely don’t know a ton about it, but I’d be willing to bet that the EPS (earnings per share) of Tesla probably isn’t that important to its long-term success. Whereas the error rate, like you said, that’s probably very important. If you make that a KPI, track that, and see it moving in the right direction, that’s probably a lot more important than the EPS. You need to get a little bit more familiar with the business, develop your own KPIs, and then make your thesis around that.

Simon Erickson  30:52

Let’s be fair, too, Robert. The stock market is starting to look more like a venture capital market every year. Silicon Valley has changed the way that people invest because it’s not just about capital anymore. It used to be. 50 years ago, if you had the chemical plant, and nobody else had the money to build a chemical plant, you own the market. Even before that, Standard Oil. If you had the oil refineries, nobody else had them, then that was your competitive advantage. But now, there’s money out there for everything. And so, the advantage has to shift from being capital and steel-in-the-ground and factories to something that’s a little bit more ethereal, like data. We always hear data is the new oil. Who’s harnessing that? Who’s taking advantage of that? How do you build a competitive advantage out of that? That’s something that these venture capitalists like John Doerr has figured out for decades. You have to look at something different than what everybody else is looking at out there because those are the companies are shaping the future. It’s a fascinating time to be an investor.

Robert Leonard  31:45

Also, I talk about this from experience. I am by no means an expert nor a perfect investor, but when I first got started, I was investing entirely based on Wall Street traditional metrics. I’d run a discounted cash flow analysis, and say, “This is trading at a low P/E. This must be undervalued.” And I’d buy it. Little did I know as I was inexperienced at the time, I didn’t understand that there was no catalysts on the horizon for the market to realize the “undervalue” that I saw. I just wasn’t looking at the right KPIs for the businesses. Maybe the earnings per share that I was valuing didn’t matter.

And so, I’m just talking about this from experience. I’ve learned over the years that you need to find the things that might even be qualitative. It might not even be a specific data point, but it’s a KPI that you need to watch. That’s where you can really unlock a lot of value.

Now, you mentioned the management team is probably the first thing you look at. Do you eliminate a company before spending hours researching it? Is that a purely qualitative thing? Or are there metrics that we can look at to really identify a good management team?

Simon Erickson  32:45

I think it is mostly qualitative. You know, you can have some metrics using harder numbers that are written into the comp plan that they have. It’s even better if they’re saying on conference calls, “Here are the internal metrics that we are holding ourselves to accountable to.” That may be a little bit more quantitative, but management is such an art. Are they being upfront with you about things that are going on out there?

Starbucks’s CEO got right ahead of this Coronavirus situations, and said, “Hey, this is what’s going on out there. We’re significantly reducing our 2020 guidance,” before almost any other company was saying anything. They were ahead of the game. The stock took a hit for that. You have to applaud the management team that’s willing to go out there on record and say something.

Acquisitions are notoriously overly bullish. People get too excited about buying a company, bringing them in, talking about these financial synergies and all these things, but you have to have an objective. Look to those. Some management teams do that, but other management teams don’t.

One company I really like right now is a company called Broadcom because their CEO is objective to the max about making acquisitions. Where a lot of companies don’t do really good acquisitions, Broadcom very, very often does great acquisitions, and that’s creating value over time. So, it’s stuff like that. One part of it is the numbers, but I think even more so is the track record. Have they earned your trust as an investor in that company?

Robert Leonard  34:15

Just to bring it back to the personal piece, some people are going to be okay with a management team doing one thing, and they’ll earn your trust that way, and somebody else is going to feel different. They could be more willing to accept the management’s trust by doing something else. So, two different people can look at a management team and decide if it is a great management team, or this isn’t the right management team. For me, I’m not necessarily trusting them with my capital or running this business. So again, bringing it back to personal. A lot of things or investing are personal.

So at what point would you say that you’ve gathered enough information and you’ve conducted enough research that you’re comfortable to start a position?

Simon Erickson  34:51

When you become comfortable thinking you’ve looked through the annual report enough, you’re comfortable about the management team, and you see what you like after setting some metrics. Maybe that’s a great time to take a small stake in the company.

Don’t pack the truck up and say, “Okay, I read the 10-K. Here are my life savings. I’m putting it all into one company.” That’s basically like going to Vegas, right? You have the same odds as something like that. But if you do it a little bit more measured in approach, where you say, “Okay, I like what I see. Maybe I’ll put in a really small position, like $100.” You can buy fractional shares in the market now, and nobody’s charging commissions anymore.

You can buy Amazon, which is trading for several thousands of dollars a share. You can buy $10 with Amazon right now, if you wanted to, just to get some skin in the game, to see an actual number attached to it, and to see how that’s doing over time. Then, what I like to do is personally add to positions that I see are doing well a second time, a third time, a fourth time, and so o, until I reach a certain maximum amount that I want to invest in a company. That gets me started by saying, “Okay, I’ve see what I like. Here’s a little bit of money.” And, just like so many venture capitalists out there that invest in a second series, third series, etc., if they like where the company is going. They can invest more money over time. You can do the same thing as an individual investor. If you like everything that you see that the company is doing, you can buy more and more of its stock over time.

Robert Leonard  36:09

Yeah, I like that point that you mentioned about no trading commissions because that’s made an impact on how I invest. I would analyze a company for a little bit, not be sure about it, and add it to a watch list. The problem with that is I wouldn’t always remember to go back to the watch list. I’m not a full time investor, so sometimes, it would fall to the backburner. I would forget to look at it or I’d forget what I researched before. I just didn’t have the skin in the game, so I wasn’t super interested in doing the due diligence I needed to do to invest in that company.

But now, because I have no trading commissions, I can buy one share or even a fraction of a share just to get that in my portfolio. Now I’m looking at it. Every time I check my portfolio, I know it’s there. I have skin in the game, and now I really put in the effort to do the due diligence, and read all of the different reports that I need to, and do the research I need to be comfortable with that company. And then at that point, I can either sell the stock because my initial thesis that was relatively surface level wasn’t true. Or maybe I double down on it because I decided that it was true, this really is a good thesis, and then I add more to it and grow into my position, just like you said.

So, for me personally, one of the biggest things I’ve learned about investing in stocks is that it’s not enough to pick the right companies. That’s obviously a very important part, but it’s only part of the equation. You’re not investing in a vacuum. So, even if the company you’re looking to invest in turns out to be great, if you’re considering another company or invest in opportunity that turns out to be better, you actually had a less than optimal portfolio allocation.

When making a decision to buy a company stock or not, how much do you weigh other potential investment opportunities in comparison to the company you’re considering?

Simon Erickson  37:48

So that’s a two-beer conversation. That’s a very difficult question to answer. It’s a very personal question to answer because it’s all about allocation. It’s always easier to buy stocks than to sell stocks. What I mean by allocation is, okay, you found five companies you like, you buy all five of them with equal amounts for each one. But then which ones do you add to? Do you want to sell one of those? Should one of those really still be a 20% stake in your portfolio? All of these are difficult, and there’s no magic answer for any of them.

The only thing I would I would recommend is to put the highest allocation into the companies you have the most conviction in.The old school way of thinking of this is to put the most percentage of your portfolio in the lowest risk company. If you’ve got Tesla and you’ve got Walmart, put more money at Walmart because Walmart’s going to be around tomorrow, and we think Elon might be crazy and spend all of his money on crazy things. That was the old way of thinking about things. But that doesn’t really account for the fact that there are “growth companies” or riskier companies out there that, either because they’re priced incorrectly, or they’ve got such phenomenal opportunities, or they’ve got the right leadership team in place, or whatever it is. It’s okay to have, in my opinion, larger percentages to smaller companies that are riskier.

But back to the question, though, it’s all personal. It’s all opportunity costs. As an investor, you have to always be thinking in terms of, “Okay, this isn’t just one company I like anymore. Now I’m investing in 10-50 companies or so that will influence the overall returns of my portfolio.” And you want to maximize your returns, not necessarily just invest in low risk stocks. At least for me, personally, I’m always thinking about in terms of opportunity costs, and I balance my allocation. I’m not afraid to take a 20% stake in a company, even as a risky growth-style investment, if I really believe in its future.

Robert Leonard  39:45

I bring that up because I feel the same way. I think it’s so important. Recently, over the last couple of years, that’s one of the things that I’ve really been focusing on with my investing. It’s at opportunity cost. Because when I was first starting, I’d run my discounted cash flow, it would look good, I’d buy it, and then in a month, I’d want to buy another company because that looks even better, but I’d have no cash left. And so, then I might have to sell that other company, but I didn’t give it time for my thesis to play out, so maybe I had a loss. So, I had to sell that for a loss to buy this other company, and it just didn’t seem like the optimal way to invest.

I started to do some research into that. I started to read a lot about this opportunity cost idea. It’s been even more prevalent lately with this market decline because we have a Facebook group where people that are part of the community that enjoy the podcast are at. We all talk about stocks, real estate, investing, and all kinds of different investing topics. And a lot of people have been pitching Carnival Cruise Lines. To almost every person, I said, “That might be the right investment for you, and it might do great. But for me, that opportunity cost of what that would do versus what I can invest that money in, it just isn’t right. For me, I’m a very big bull on MasterCard.” And so I tell these people, “Could I invest that money in Carnival Cruise Lines, or could I put that on MasterCard?” When I think about those two things, it’s the opportunity cost. Maybe Carnival Cruise Lines, which is ticker CCL, would turn out to be great, but for me that opportunity cost. I’d rather have that in MasterCard. And so, that’s really the reason as to why I wanted to ask that that tough question of you.

Simon Erickson  41:08

It’s a great question too. It goes back to being personal again, right? There’s no right or wrong way to be an investor. At the end of the day, if you’re investing in a lower-risk company that is paying out most of its money as dividends, it just says, “We don’t want to spend all of our money on growth. We don’t want to build a Gigafactory in Shanghai. We want to distribute it out as cash to you as a dividend.” There is nothing wrong with that. You can sleep very well at night just saying, “Hey, every three months, I’m getting a dividend check from this company.” At the end of the year, it adds up to maybe 4% or 5%.

I think about a company like Lowe’s. Lowe’s has very mature operations, home improvement, great. They have reliable customer base, great. They don’t need to go out and build 10,000 more stores. They say, “Okay, we made a lot of money this year. We’re going to give it back to you as a dividend.” This is an income investment. Now Lowe’s is not going to shoot to the moon because, at least how the business is built today, we don’t think it’s going to increase 400% in the next year. But are you comfortable getting dividends because that’s a lower risk thing that makes you feel good as an investor? There’s nothing wrong with that at all. That’s a great strategy. But if you start taking those dividends, reinvesting them over time, and buying more stock that’s been paying you more dividends, you can add that up over 10 years. 10-20 years of a company like that can be worth a fortune when you start pulling money out of that investment.

And so, there are different styles. You don’t always have to shoot for the moon. There’s a lot of excitement in growth companies, but there’s also a lot of excitement and making a lot of money on a steady growing company too.

Robert Leonard  42:39

Yeah, believe it or not, I’ve actually seen a lot of millennials recently take an interest in dividend investing. On YouTube and across different social media platforms, I’ve seen a lot of millennials be interested in dividend-paying stocks. It’s really interesting to me. I think that’s because of the rise in financial freedom and the FIRE (Financial Independence, Retire Early) movement, and dividends play into that. I think that’s a big component of it, but it’s interesting to see that trend.

Now, a part of this conversation it goes very well with is I’ve seen you talk about upgrading your portfolio. I find it to be a very interesting concept. I want to talk about that a little bit. Tell us what you mean by this, and why it’s important for investors to consider.

Simon Erickson  43:18

Certainly. Bottom line, right now, everything’s on sale. The market has down in the last month. The S&P is down definitely over 20% last month, so you’ve got really high quality companies that are selling at a discount from where they were a month before. So, the idea is, rather than be paralyzed, and say, “I’m not buying anything. I’ve already invested all my money. I don’t have any cash. I don’t want to invest any more money into the stock market.” There is nothing wrong with selling positions that have decreased in value if you can buy something else that has also decreased in value that you think is a better opportunity.

The question becomes then, of how you define quality. Is it a cultural advantage that they have? A decision-making process that they’re doing better? Is it regulations? Is it growth of the market that they’re taking advantage of? You’ve got zillion different metrics and things that you can look at, but I have been taking advantage this past month, too. Even though they’ve decreased in value during the past 30 days, selling some of those what I consider lower-quality companies to buy what I also think have higher-quality companies, I think that, in the long term, you’ll want to look for quality, and so that’s going pay off.

Robert Leonard  44:27

We’ve alluded to it a few times, and we probably couldn’t record a podcast episode right now, which is March 24 2020, without at least mentioning the current environment that we’re in, which is the Stock Market Crash of 2020, as some people are calling it, and the COVID-19, also known as Coronavirus. How has this impacted the investing landscape? What long-term impact do you see this having on stocks?

Simon Erickson  44:53

This is a great question because every price brings opportunities with it. Every time something really bad happens to the economy, there’s a permanent change that happens. 2001, dotcom bubble burst. All of a sudden, every company that was really overvalued based on the web traffic and the advertising that was that it was attracting had to rethink things and say, “Okay, we need to start focusing on more predictable cash flows.” They start shifting to being subscription-based, instead of advertising based. 2008, same thing happens, financial crisis. Weak internal controls for a lot of financial institutions. They said, “We have to look at some different data. We have to make better loans.” You start seeing these alternative lenders popping up, this new FinTech movement, which one of the guys on my team, Matt Cochran, is really looking right now.

There is incredible opportunity because companies are starting to realize we have to get smarter about making better loans all across financial services. In my opinion, Robert, the Coronavirus crisis is going to accelerate the shift of things that are not already being done on the internet to being done on the internet. We already know Amazon’s an awesome company, but it doesn’t have everybody in the world buying from Amazon. And if you weren’t buying online or retail, you’ve been doing it this last time month, right? You’re on lockdown at your home. You’re not going to the bricks and mortar retailers anymore. You’re having to learn about this crazy thing called the internet where you can buy things through e-commerce. So, that’s going to be a huge jump in that.

Another big change is, in my opinion, that healthcare is going to start moving online. We are seeing a spike that our hospital system cannot handle right now. There are too many patients going in. It’s crazy in the hospitals. I’ve got some buddies who are doctors. They say it’s very overwhelming right now. And so, there has to be a way that patients can get diagnosed for simple conditions that are not life-threatening at home. You can do that over Telehealth. You can do consultations with doctors over the internet now. It has to be an easier way to get low-cost healthcare and drugs to them, too. We’re starting to see pharmacies where you can actually go in minute clinics. You can go to grocery stores, CVS stores, etc., and get checked out for simple conditions, and get prescriptions written right there. There has to be a lower-cost healthcare system that’s more available to where people are rather than just jamming everybody in the hospital.

Robert Leonard  47:03

Yeah, I am a big fan of the FinTech movement myself. Three of my five biggest positions are in the FinTech space. I’m a huge fan of that. A lot of my background is in financial services. I understand that. It’s in my circle of competency really well. It’s an area I really like.

To your point about things going online, I completely agree. I see it the same way. The company I work for full-time outside of the podcast was already pretty progressive in terms of using technology, but we’ve even been talking about how this is going to change our business, and how we can do X, Y, and Z online now going forward when we hadn’t done it before, not because we couldn’t, but just because we’d never thought to change something that was working. We never thought we needed to, and so now, going forward, that’s going to be a big change.

And to your point about healthcare, I agree with that, as well. I was a shareholder of Teladoc. I had the same kind of thesis a while ago. Unfortunately, I owned it around $50s, and sold it around $70s or $80s. If you look at the stock today, I believe it’s up to around $130 or $140, so there was a little premature selling on my side. But I definitely do agree that that trend is going that way.

So, in a time where there is so much volatility and so much concern, both economically and from a public health perspective, how are you approaching investing at a time when we’re experiencing a black swan event?

Simon Erickson  48:22

I’ve been buying stocks even as they’ve been decreasing. I’ve been seeing them fall 10% right after I buy them. Generally, when I buy a stock, over the next 10 minutes, it drops 10%. I guess it’s a curse? I don’t know. It used to be that 10% move in a single day was a big deal. Do you remember when that was a big deal? It’s not a big deal anymore to see a stock increase or decrease in value by 10%. It’s crazy times.

At the end of the day, it doesn’t bother me. If you’re investing in years, instead of minutes, or days or months. It doesn’t matter. The goal is to make money in the stock market. It’s very difficult to time this thing. There are so many variables. It’s almost impossible to call where the bottom is going to be for the market in general, or even for any specific position. But when you see again these really high quality names decreasing 30-50% in a month, that gives you a really nice margin of safety as an investor. And so, I have been very actively putting cash to work.

I think even today, we’re filming here on the 24th. Today was the best performing day for the Dow since 1933. The Dow is up over 10% today, it’s incredible. But even today, we still haven’t gotten back a lot of those losses from the past month and Coronavirus. It could still fall worse from here, depending on what Washington does, depending on how the treatments and the hopeful eventual vaccine goes. There are still a lot of variables out there, but I think of investing in terms of years. I think this is a great opportunity. Don’t get too concerned over a day or a week if you’re investing for five years. Look at the stock chart over five years instead of five minutes.

Robert Leonard  49:57

What do you think is the biggest mistake you see new investors making? And how can listeners of this show avoid that same mistake?

Simon Erickson  50:05

I think that the biggest mistake for most investors, not even beginning investors, but just investors in general, is selling too quickly. That goes for me as well, too. There were stocks I bought in 2008, which was the last really big crisis we had, that I thought I was the king of the world because I got 100% return on it. I was excited that this company that I bought doubled in price. I thought I had to sell. I have to take my gains in. And then, you see it go on to have a 400% gain, and I said, “Man, how much money did I leave on the table?”

I got so excited about selling something for a game, that I lost track of the long-term focus. I told myself that I needed that. And so, my piece of advice would be: “Don’t anchor on the percentage return that you’ve made or that you’ve lost.” Every day in the stock market is a new day, and the market doesn’t care what percentage you made or lost on your stock. It’s going to go on and do its thing. And the companies that are creating value, if they’re continuing to do a good job with that, and you don’t need the money to pay for your mortgage or whatever bills you have, let your winners run. Don’t be fixed on getting too excited about a double of a stock. Selling is very hard. It’s much harder than buying. But my one piece of advice would only sell if there’s something you really don’t like, rather than just you get excited about the bottom line.

Robert Leonard  51:25

It’s funny that you mentioned that. It’s actually very timely for me because I bought a small position in Zoom not that long ago. It’s up over 120% in a relatively short period of time. Now, I’m grappling with that exact dynamic you just mentioned. It’s up 100%, over 100%. It’s doubled. Now what do I do? Do I sell it and take my gains into something else? Or do I continue to let it run? I think I’m going to fall on the side of exactly what you mentioned. I’m just going to continue to let it run. I like the company. I still believe in the thesis. I’m just going to continue to let it run from here. There hasn’t been been a material change.

What is a common piece of advice that you hear experts giving, whether it be on social media, just generally across the internet, that you don’t necessarily think is great advice? And how would you make it into good advice?

Simon Erickson  52:12

The first thing is turn the other direction and run if you ever hear anybody say the trend is your friend. We spend way too much time looking at stuff like that, and that’s not fundamental stock market analysis, in my opinion.

The second thing is I think there’s this kind of conventional wisdom that when the market is falling, you’re supposed to be more conservative. People think, “The stock market’s going down. Sell all your stocks and go to cash.” Or, “Double down on value stocks or conservative stocks.” I don’t really agree with that. I think that when the market falls, there are a lot more opportunities that can still be growth-style invested. 

And if you look at the returns or Beta, which, in financial services, is a great way to kind of measure how much a company or a stock is going to return based on the broader market when things go badly. Smaller growth companies that are riskier tend to get hammered. They sell off like crazy. But then, when things turn around, they also tend to have really good returns. There are more people, they have thinner trading volumes, they have less people, and then lower market cap. There are a variety of reasons. And so, the adage of “go conservative and put all your money in cash during a downturn,” kind of defeats the mathematics of that. You want to be going for the opportunities.

When there’s a market downturn, it’s a huge opportunity for you as an investor, especially as an individual investor. When there’s a lot of money in funds, they don’t want to be taking those calls from clients saying, “Oh, why are you putting me in growth-style investment? Why are you buying these small market cap companies? I want all my money in cash right now.” You don’t have those same kind of rules, so my advice would be to take every crisis as an opportunity to be a long-term investor.

Robert Leonard  53:47

There’s so much more that I’d love to talk about. I could talk for hours about this stuff, so we’ll have to have you back on the show again. But I know I’ve learned a lot, and I really enjoyed this conversation. I can only imagine that the audience will as well. Where can those listening to the show today go to learn more about you and connect with you further?

Simon Erickson  54:06

Thank you for this opportunity, Robert. Everyone in my company is a big fan of your podcast, and of you, as well. I’m very honored to be here.

You can check out our site at 7investing.com. We are also very actively involved on Twitter. I am personally @7innovator on Twitter. We also have a handle for our company, @7investing. Again, I refer back to our mission statement.

Our mission is to empower you to invest in your future. We do that through our subscription by offering our best stock ideas, which is what I just mentioned. But we’re also really trying to help people out there, too. So please, send us questions on Twitter. We’ll answer them. Send us direct messages on Twitter, we’ll answer them. We are here to serve you as individual investors. We want to empower people. There are no dumb questions. We’re all learning from this together. I think that the stock market is the greatest wealth-building tool for people that’s available. There’s a lot to learn, and we can learn from each other out there. It’ll provide for whatever it is you’re willing to save your money for in the future. We really want to empower that mission, so please feel free to reach out to us. We have a lot of free stuff on our website. We’re really excited about what we’re doing.

Robert Leonard  55:10

Simon, thanks so much for those kind words. I really appreciate it.

I’ll be sure to put links to everything that Simon just mentioned in the show notes so that everybody listening to the show can go check that out. I also put links to various different resources that relate to the topics that we talked about throughout the show, so you can go read up on that more, as well.

I’m a big fan of everything Simon and his team are doing. I follow them all on Twitter. We’re all very active. Definitely, be sure to go follow them. They’re great people to follow. You’ll learn a ton of great information. Social media won’t be so much of a time suck anymore. You’ll actually be able to use it as an educational opportunity. I really highly recommend you go do that.

Simon, thanks so much! I really appreciate you coming on the show.

Simon Erickson  55:48

Thank you very much for having me!

Robert Leonard  55:50

All right, guys! That’s all I had for this week’s episode of Millennial Investing. I’ll see you again next week!

Outro  55:56

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