My Speech in Key West

Here is a speech I gave to the Sunrise Rotary Club in Key West this morning. I went a bit off-topic in various parts but tried to capture everything in the version below.

Good morning, everyone. Before I even start talking about investing, I wouldn’t be a good Rotarian if I didn’t plug the Upper Keys Rotary’s Gigantic Nautical Flea Market. It’s Saturday & Sunday, February 26 and 27 at Founders Park in Islamorada – and if you’ve never been, it’s a huge event and we raise a ton of money for scholarships. If you can’t come, I hope you’ll help us get the word out. I’ve got some brochures over on the table if you’re interested.

Thank you for having me. I’m Cale Smith, and in August of 2008, I started my own independent firm, Islamorada Investment Management. I’m a portfolio manager, which means I run two funds that I created. My background prior to starting my firm was as a stock analyst – not as a broker or financial planner, but being focused on just researching and analyzing public companies, and sometimes telling the guys who run the funds what to buy or sell. And now that’s all I do – run those two funds of my own. I still don’t do financial planning, or buy or sell stocks for other people, although I have plenty of strong opinions about how a lot of those things are usually done on Wall Street.

I built my firm to focus on what I most enjoy – analyzing companies – and I don’t make money on commissions, referrals, or hidden fees. IIM is a fee-only firm, which means my fees are based just on the amount people invest with me. I am also a big fan of Warren Buffett when it comes to investing – I’ve made the trek to Omaha with 70,000 other people to attend the annual meeting of his company Berkshire Hathaway, and my own investing philosophy is probably about 90% Buffett. I also don’t own any other stocks, bonds or mutual funds…every dime my family has saved is in the two funds that I run, so I eat my own cooking, as they say.

In any case, the summer of 2008 was a pretty auspicious time to start an investing business…you’ll remember that was a few months before Lehman Brothers imploded, before Merrill Lynch sold itself to Bank of America, and before anyone had ever heard of Bernie Madoff. Investors were running for the hills back then – which made for a terrific time to start an investment firm, actually. I’m happy to say that both the funds I run have doubled in value since launching them, though it’s been anything but straight up. The past few years at times have felt like dog-years. There are as you probably already appreciate some real challenges to being a good long-term investor these days, even for professionals – and that’s what I really wanted to talk about this morning.

If I had a formal title to this little presentation, I think I’d call it “Wall Street: Yes, it’s Become a Big Casino – But Here’s the Silver Lining.” That’s the silver lining for the motivated long-term investor, anyways…I think everyone here already has a pretty good sense of the downside in the casino.

And if there is only one thing that sticks in your mind later on today, I hope it’s the answer to this question:

Would anyone care to guess what the average holding period for a stock is these days?

In other words, what is the average amount of time that elapses between when someone buys a stock, and then sells it?

Anyone?

22 seconds. The average amount of time that an investor held a stock in 2010 is 22 seconds. I think that’s just stunning. The real irony, though is that 22 seconds is actually an improvement, because in 2009, the average holding period was only 20 seconds.

Now why is that? Well, it turns out that the reason it’s only 22 seconds is because about 70% of all the trades that happen every day on Wall Street are actually being done by computers. And much of that is called high frequency trading, and it is literally machine versus machine, algorithm versus algorithm, competing in milliseconds. Do you remember that movie War Games that came out in the 80’s, with the big green mainframe computer – it was called WOPR – that almost started a thermonuclear war? These computers and their programmers put that machine to shame. They’re more like giant vacuum cleaners that cruise around the markets sucking up fractions of a pennies at a time, making billions.

It’s not just the computers that make it a casino, though. There’s the derivatives – a whole other subject which I am tempted to skip, because it makes people’s eyes glaze over – but which I think is important to at least acknowledge. Anyone heard of credit default swaps? Never mind all the jargon about them…here’s an analogy that I think best illustrates what they are all about.

Let’s say Josie over there knows that Ron here is a horrible driver. She calls the insurance company and takes out a policy on Ron’s car, because she’s got a feeling that something bad might happen, and she figures she might need some money if it happens to her.

You can probably sense something isn’t quite right in this scenario, and you’re correct. There are a handful of problems. The first is that Ron has no idea Josie has taken out an insurance policy on his care. The second issue is that even though Ron’s car is only worth $10,000, Josie can take out an insurance policy for $1 million. The third issue is that Ron’s other neighbors can also start taking out insurance on his car, too – not just Josie. So before long, the entire neighborhood is insuring Ron’s car.

Now I’m not saying that Josie is going to sneak out one night and cut Ron’s brake lines – but I am saying that should something untoward happen to Ron’s car, nobody is going to complain. In fact, his neighbors would make a lot of money, so I think it’s safe to say they might be happy about it.

Credit default swaps are institutionalized speculation – and they will still be, in spite of this financial regulation that passed last year. They are often traded by 27 year-olds in midtown Manhattan over instant messenger. And if you totaled up the GDP of every country in the world, those trillions would still be dwarfed by the outstanding notional value of credit default swaps floating around. It’s a huge number.

The third reason the Street resembles a casino is also due a certain kind of culture that can be hard to articulate without offending the good folks who work on Wall Street. Or casinos, even. I don’t watch a lot of TV, but somehow I happened to catch 60 Minutes last weekend, and I thought there were a few seconds in the show that typified that culture. The show did a segment on the man believed to be the world’s best sports gambler. Makes millions in Vegas, daily, betting on sports. This guy was apparently the undisputed prince. I thought it was pretty telling, though, when the interviewer asked him, “Have you ever been hustled by anyone?” Sure enough, his answer started out, “Well, a couple of years ago, there were some guys from Wall Street here…”. Turns out this prince been out-hustled by the real gambling kings.

In any case, it’s not my intent to rail against Wall Street all morning. It’s too easy, honestly, and it will eventually make you a bitter cynic. And I think this goes without saying, but I’ll say it, anyways – I am an ardent believer in American businesses. Just don’t confuse free markets with what goes on on Wall Street.

So my point is basically this: in spite of all the chaos and at times just pure insanity out there, you can, as an individual investor, still do well. And I tend to think there are really two reasons why.

The first reason is that because, in my opinion, everything important that you really need to know about successful investing has already been written down.

You can become a really good investor by reading two books by a guy named Benjamin Graham written back in the 30’s and 40’s. And actually, that’s not necessarily just my opinion. The empirical evidence that is Warren Buffett and his $50 billion net worth would also support that same notion. Plus, nowadays, you can learn direct from Warren Buffett himself by reading all of his letters to his investors in Berkshire Hathaway. Even better – those letters are all available for online. For free. If you did nothing else but read those books – Ben Graham’s Security Analysis and the more accessible The Intelligent Investor – if you read them slowly and deliberately and really internalize them, I think you’d be better off than 90% of the other investors out there – professionals included. You’d be surprised how little structure there is to the way most professionals invest.

The second reason that I think individual investors can still compete really comes down to this:

Wall Street puts too much emphasis on talent and pedigree, and not enough on plain old hard work.

If Wall Street were an NBA team, it would be the one that, every year, drafted only high school seniors who look great on paper. Most people don’t do the work in actually analyzing a company – they take shortcuts, all the time. That’s true on the Street, too – but at times it’s more complicated because the guys who are doing the work have conflicts or allegiances you aren’t aware of.

The Street is really built on this idea that certain people are just rock stars – born to trade. The higher echelons of Wall Street tend to hire just those people with Ivy League backgrounds, and who have, let’s say, a common worldview – and I think that obsession with “talent” is also why those guys are paid such ridiculous sums. It’s also why people seem to hang on the every word of whoever this week’s market guru might be.

But that talent is a myth. I would have thought 2008 would have proved that to the world, but people forget quickly. After a certain point, pedigree is meaningless, and it’s your work ethic that matters.

My point is that if you do the work – if you really read company filings and put the time in when reviewing their financials – and assuming you can think ahead more than 22 seconds – you stand a pretty good chance of beating many of the guys on Wall Street over time.

So for those of you with the interest, I would encourage you to try to become a better investor, as opposed to being a consumer of financial products. Now, valuing a business is a subject worthy of a whole other talk sometime, but its not as difficult as you might think, either. If you have run, worked at or managed a small business in your life, I’d say the odds are pretty good that you’re already better at it than you might think. There really isn’t much difference between counting the cash in the register every night, and what I do all day long.

To be clear, I think you need to have an investing philosophy, especially when things are uncertain like they’ve been the past few years. I think Buffett’s philosophy is the place to look, but his may not be the right one for you. There are certainly others to consider. But I would urge you to find one that makes sense to you and stick with it – or find someone who you can trust to do it for you. As one of my other favorite investors once said, “Investing without a philosophy is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”

And with that, I’m happy to take any questions you might have.

There was some good back and forth in the informal Q&A that followed afterwards, which I would summarize like this:

I am not a strong proponent of aggressive regulations. I think it’s ridiculous that I can’t build a shed in my own backyard without getting permission from someone in the local government planning office. But it’s a big mistake to think that the same annoying hassles that we all put up with every day are magnified even more for Wall Street firms. It’s just the opposite. The rules have been written to enable them, really.

I think the thing that’s been missing on the Street for too long is just plan accountability, and that is, by definition, hard to regulate. To continue that earlier analogy, Wall Street right now is like the NBA – you’ve got a ton of very motivated, ultra-competitive people banging heads night after night – only it’s been expected that they’ll call their own fouls, and they won’t get paid unless they win.

You need a referee to have at least some boundaries, both in the NBA and on Wall Street, or else things eventually just stop working. And as much as the players complain about the refs, most of them also realize they help keep their competitors in check, too. So I think this is all much bigger than politics.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.

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