Editor's note: Over 20-plus years of investing, it's easy to pick up a few lessons along the way. In today's Weekend Edition, we're taking a break from our usual fare to share this essay from Whitney Tilson, which was last published in the Stansberry Digest Masters Series in February 2024. In it, Whitney follows up yesterday's issue with four more lessons for investors seeking long-term investment success...
Yesterday, I shared three important lessons that I've learned from more than two decades on Wall Street...
- Beware of speculating, avoid the hottest sectors, and think independently.
- Let your winners run.
- Tune out the noise and focus on fundamentals.
And today, I'd like to share four more lessons you can use to start improving your investment results...
Lesson No. 4: Dig Deeper Than the Bottom Line
To be a smart investor, you need to 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"?
Since that'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 compared with just $815 million over the same period in 1998.
But the cash-flow statement told another story... Cash flow from operations was negative $1.3 billion in the first three quarters of 1999 versus $1.6 billion the previous year, a swing of $2.9 billion.
It turns out that Lucent was selling to many dicey startup companies that were struggling to raise 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 avoided a bloodbath. The stock collapsed to around $2 a share.
Lesson No. 5: Beware Serial Acquirers
My next lesson 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 or industry is at a peak and valuation multiples are highest. What's more, 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. That greatly increases 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. 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 more than $1 trillion empire.
We've also seen brilliant acquisitions from Google parent 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.
Lesson No. 6: Don't Short... But Do Listen
This lesson may surprise folks familiar with my work: Avoid shorting, but respect short sellers...
During my 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, fall a lot).
To survive, short sellers have to be extremely intelligent and do outstanding in-depth research – far more so than traditional long-only investors. So 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 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. Sometimes, short sellers will put their work out there publicly by releasing reports, publishing articles, and speaking at conferences. But for the most part, 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 they reflect extreme negativity toward a stock.
A good example of this is my trade on Netflix (NFLX). The stock was trading at a split-adjusted $7.78 per share on October 1, 2012, down more than 80% from its July 2011 high. 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 more than $500 billion... while remaining 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 survived the historic bull market had to have been good. They were swimming upstream against a powerful current for a decade!
Lesson No. 7: 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.
Best regards,
Whitney Tilson
Editor's note: According to Whitney, we're on the cusp of the most transformative event in human history. And it's all thanks to an AI "super chip" that's 50 times faster than Nvidia's. That's why he has asked the man who recommended Nvidia before its 18,300% rise to join him for this presentation. But time is running out... Learn how to position yourself before next Wednesday.
