reading

Cover image: Ticker tape, Anotonio Petruccelli, Reproduced by permission of Mike Petruccelli

Cover design: Jennifer Gallagher

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.

Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

Names: Sonkin, Paul D., 1968-author. | Johnson, Paul, 1960-author.

Title: Pitch the perfect investment : the essential guide to winning on wall street/Paul D. Sonkin, Paul Johnson.

Description: Hoboken : Wiley, 2017. | Includes index. |

Subjects: LCSH: Investments. | Securities. | BISAC: BUSINESS & ECONOMICS/ Investments & Securities.

Classification: LCC HG4521 (ebook) | LCC HG4521 .S71196 2017 (print) | DDC 332.6–dc23

LC record available at https://lccn.loc.gov/2017013999

Contents

Cover

Preface

Notes

Introduction

Notes

PART I THE PERFECT INVESTMENT

Chapter 1 How to Value an Asset
1. Three Primary Components of Value
2. Gems
3. Notes
Chapter 2 How to Value a Business
1. Defining Cash Flow
2. How to Calculate Present Value Using a Discounted Cash Flow Model
3. Predicting the Future Is Not Easy
4. How to Calculate the Present Value of a Bond
5. How to Calculate the Present Value of a Perpetuity
6. How to Calculate the Present Value of a Business
7. How to Calculate the Present Value of a Growing Cash Flow Stream Using a Two-Stage DCF Model
8. How to Think About the Discount Rate
9. Gems
10. Notes
Chapter 3 How to Evaluate Competitive Advantage and Value Growth
1. Cash Flow Generated by Selling Assets
2. Cash Flow Generated by Operating the Assets: Return on Invested Capital, Cost of Capital, and Excess Returns
3. Gems
4. Notes
Chapter 4 How to Think About a Security’s Intrinsic Value
1. What is “Intrinsic Value”?
2. Thinking of Intrinsic Value as a Range of Values
3. Gems
4. Notes
Chapter 5 How to Think About Market Efficiency
1. Market Efficiency Is More of a Concept Than a Law
2. The Holy Grail of Money Management: Generating Alpha
3. Generating Alpha Is a Zero-sum Game
4. Defining Market Efficiency
5. The Rules of Market Efficiency
6. When the Rules of Market Efficiency Operate Flawlessly
7. The Mechanism That Implements the Rules of Market Efficiency
8. Gems
9. Notes
Chapter 6 How to Think About the Wisdom of Crowds
1. “And the Oscar Goes to …”
2. The Wisdom of Crowds Is Critical to Market Efficiency
3. How the Wisdom of Crowds Implements the Rules of Market Efficiency
4. Tenet 1—The Dissemination of Information
5. Tenet 2—The Processing of Information
6. Tenet 3—The Incorporation of Information
7. Examples Illustrating How the Wisdom of Crowds Implements the Rules of the Efficient Market Hypothesis
8. The Wisdom of Crowds Applied to the Stock Market
9. The Crowd Is Smarter Than the Experts Most of the Time
10. How the Crowd Can be Fooled
11. Gems
12. Notes
Chapter 7 How to Think About Behavioral Finance
1. The Moody Mr. Market
2. When the Wisdom of Crowds Becomes the Madness of Crowds
3. Is the Crowd’s Apparent Madness Irrational?
4. How Can Fama and Shiller Both Be Right?
5. The Magnetism of the Efficient Market Hypothesis
6. Limits to Incorporation: When the Crowd Cannot Act
7. The Efficient Market Hypothesis Remains “King of the Hill”
8. Why Do We Care About Market Efficiency?
9. Gems
10. Notes
Chapter 8 How to Add Value Through Research
1. Informational Advantage
2. Analytical Advantage
3. Informational + Analytical Advantage
4. Trading Advantage
5. Catalysts
6. Gems
7. Notes
Chapter 9 How to Assess Risk
1. The Difference Between Risk and Uncertainty
2. Confusing Uncertainty and Risk Causes Mispricings
3. How Confusion of Risk and Uncertainty Manifests in the Wisdom of Crowds Framework
4. When Uncertainty Becomes Risk
5. Margin of Safety Is Really All about Risk
6. A More Certain Business Can Actually Be Riskier
7. Time Matters . . . and Matters a Lot . . .
8. How Increased Accuracy and Precision in Estimating Intrinsic Value Affects Risk
9. How Increased Accuracy and Precision in Estimating Time Horizon Affects Risk
10. Risk and Variant Perception—Skewing the Distribution in the Investor’s Favor
11. The Risk of Underperforming
12. Gems
13. Notes

PART II THE PERFECT PITCH

Chapter 10 How to Select a Security
1. The Importance of Matching a Portfolio Manager’s Schema
2. Identifying a Manager’s Fundamental Criteria
3. What Went Wrong?
4. Identifying a Manager’s Valuation Criteria
5. Other Barriers to Adoption
6. Overcome Barriers by Learning How to Read a Portfolio Manager’s Mind
7. Other Communication Pitfalls
8. Gems
9. Notes
Chapter 11 How to Organize the Content of the Message
1. How to Capture and Keep a Portfolio Manager’s Attention
2. Constructing a Formidable Argument Using the Toulmin Model
3. The Stress-Tested Argument
4. Gems
5. Notes
Chapter 12 How to Deliver the Message
1. The 30-Second Hook
2. The Two-Minute Drill
3. Make It Easy for Them
4. Topography of a Simple Slide Deck
5. How to Handle Q&A?
6. Stock Pitching Contests
7. Delivering the Message—You Are the Envelope
8. Anatomy of a Meeting
9. Other Not So Obvious Barriers to Communication
10. How Do You Get to Carnegie Hall?
11. Gems
12. Notes

Acknowledgments

Notes

Art Acknowledgments

About the Authors

Index

EULA

List of Illustrations

Introduction

Figure I.1 Factors Influencing the Value of an Asset
Figure I.2 Present Value of $100 Two Years in the Future
Figure I.3 Present Value of a Plain-Vanilla Bond
Figure I.4 Competitive Pressure Drives Excess Returns to Zero
Figure I.5 The Three Rules of Market Efficiency
Figure I.6 Market Efficiency and Behavioral Finance Coexist
Figure I.7 Two Potential Errors to the Consensus Expectations
Figure I.8 Accuracy and Precision Matter
Figure I.9 Precision and Accuracy Substantially Reduce Potential Risk
Figure I.10 Questions to Achieve the Perfect Pitch
Figure I.11 Schema Used to Evaluate Bacon Sundae
Figure I.12 Portfolio Manager’s Stated Criteria
Figure I.13 Subjective Criteria Not Satisfied and Unstated Criteria Unknown
Figure I.14 Less is More

Preface

Figure P.1 Pitch the Perfect Investment Roadmap

Chapter 1

Figure 1.1 Primary Components to the Value of an Asset
Figure 1.2 Four Cash Flow Subcomponents
Figure 1.3 Getting Cash Sooner Is Preferable
Figure 1.4 A Longer Duration of Cash Flows Is Preferable
Figure 1.5 A Greater Magnitude in Cash Flows Is Preferable
Figure 1.6 Growing Cash Flows Are Preferable
Figure 1.7 Faster Growing Cash Flows Are Preferable
Figure 1.8 Stable Cash Flows Are Preferable to Negative or Declining Cash Flows
Figure 1.9 Uncertainty in the Four Cash Flow Subcomponents Affects the Value of an Asset
Figure 1.10 Single-Point Cash Flow Estimate
Figure 1.11 Range of Cash Flow Estimates
Figure 1.12 Distribution of Cash Flow Estimates
Figure 1.13 Cash Flow Estimates Become Less Certain in the Future
Figure 1.14 The Range of Cash Flows Estimates Widens in the Future
Figure 1.15 Future Value of $100
Figure 1.16 Present Value of $100 One Year in the Future
Figure 1.17 Present Value of $100 Two Years in the Future
Figure 1.18 Present Value of a Stream of $100s

Chapter 2

Figure 2.1 Present Value of Four Years of Cash Flows from Zoe’s Lemonade Stand
Figure 2.2 Present Value of Six Years of Cash Flows from Zoe’s Lemonade Stand
Figure 2.3 External Factors Affecting Cash Flows from Zoe’s Lemonade Stand
Figure 2.4 Present Value of a “Plain Vanilla” Bond
Figure 2.5 Present Value Formula Used to Value a Bond
Figure 2.6 Present Value Formula Used to Value a Business
Figure 2.7 Present Value of Zoe’s Lemonade Stand with No Growth
Figure 2.8 Present Value of Zoe’s Lemonade Stand with 10% Annual Growth
Figure 2.9 Present Value of Zoe’s Lemonade Stand with 15% Annual Growth
Figure 2.10 Main Factors of the Discount Rate Stack

Chapter 3

Figure 3.1 Cash Flow is Generated by Operating an Asset or Selling an Asset
Figure 3.2 Value from Selling an Asset: Liquidation Value and Private Market Value
Figure 3.3 Operating or Selling an Asset to Generate Cash Flow
Figure 3.4 Sevcon’s Liquidation Value
Figure 3.6 Sources of Competitive Advantage
Figure 3.7 Potential Sources of Cash Flow
Figure 3.8 Present Value of Zoe’s Lemonade Stand with No Growth
Figure 3.9 Owner Earnings Equals Excess Return Plus Capital Charge
Figure 3.10 Present Value of Excess Return
Figure 3.11 Present Value of Capital Charge
Figure 3.12 Owner Earnings Equals Capital Charge with No Competitive Advantage
Figure 3.13 Owner Earnings Less than Capital Charge
Figure 3.14 Negative Excess Returns Destroys Value
Figure 3.15 Competitive Pressures Drive Excess Returns to Zero
Figure 3.16A Nominal Incremental Owner Earnings Equals Incremental Capital Charge
Figure 3.16B No Excess Returns from Growth Creates No Value
Figure 3.17A Nominal Incremental Owner Earnings Less Than Incremental Capital Charges
Figure 3.17B Negative Excess Returns from Growth Destroy Value
Figure 3.18A Nominal Incremental Owner Earnings Greater than Incremental Capital Charge
Figure 3.18B Positive Excess Returns from Growth Create Value
Figure 3.19 McCormick: Ranges for Sources of Value

Chapter 4

Figure 4.1A Narrower Distribution of Cash Flows Is More Predictable
Figure 4.1B Wider Distribution of Cash Flows Is Less Predictable
Figure 4.2 Single-Point Estimate for Intrinsic Value of Zoe’s Lemonade Stand
Figure 4.3 Single-Point Estimates for Intrinsic Value of Zoe’s Lemonade Stand Under Different Scenarios
Figure 4.4 Distribution of Intrinsic Value Estimates for Zoe’s Lemonade Stand Assuming Different Annual Growth Rates
Figure 4.5 Distribution of Estimated Intrinsic Value for Company with Treasury Note as its Single Asset
Figure 4.6 Tesla: Individual Analyst Estimated One-Year Price Targets and Average Estimate
Figure 4.7 McCormick: Individual Analyst Estimated One-Year Price Targets
Figure 4.8 Comparing Distributions of Estimated One-Year Price Targets for U.S. Treasury Bill, McCormick, and Tesla
Figure 4.9 Sources of McCormick’s Value Presented Graphically

Chapter 5

Figure 5.1 Significant Decline in Retail Stock Ownership over the Past 70 Years
Figure 5.2 Different Types of Information
Figure 5.3 Information Dissemination into the Market
Figure 5.4 Available for a Price: Quasi-Public Information
Figure 5.5 Non-Material, Nonpublic Information Also Has a Cost
Figure 5.6 Not Available: Material, Nonpublic Information
Figure 5.7 Fama’s Available Information
Figure 5.8 Three Rules of Market Efficiency
Figure 5.9 Newport Corporation’s Stock Reprices Immediately After Takeover Announcement
Figure 5.10 An Individual’s Process for Estimating Intrinsic Value
Figure 5.11 Aggregated Individual Process = Collective Process

Chapter 6

Figure 6.1 Proper Functioning of the Collective Process Produces an Efficient Price
Figure 6.2 Insufficient Dissemination Results in a Mispriced Stock
Figure 6.3 First Rule of Market Efficiency Satisfied
Figure 6.4 Lack of Domain-Specific Knowledge Within the Collective Results in a Mispriced Stock
Figure 6.5 Domain-Specific Knowledge Is Comprised of Facts and Expertise That Form an Individual’s Processing Model
Figure 6.6 Individuals’ Private Information
Figure 6.7 Diversity of Models Produces an Efficient Price
Figure 6.8 Lack of Diversity Results in a Mispriced Stock
Figure 6.9 Mayhem Causes a Breakdown of Independence Resulting in a Mispriced Stock
Figure 6.10 Doctors’ Diagnostic Process
Figure 6.11 Second Rule of Market Efficiency Satisfied
Figure 6.12 Factors Preventing Information from Being Incorporated Results in a Mispriced Stock
Figure 6.13 Third Rule of Market Efficiency Satisfied
Figure 6.14 Individual Pen Knowledge
Figure 6.15 The Collective Is More Knowledgeable Than an Individual
Figure 6.16 Individual Decision Process Applied to the Ox-Weighing Contest
Figure 6.17 Scott Page’s Diversity Prediction Theorem
Figure 6.18 Ox-Weighing Contest: Diversity Reduces Error
Figure 6.19 Ox-Weighing Contest: Smaller Benefit of Diversity When Estimating is Easy
Figure 6.20 Ox-Weighing Contest: Steer Seer Introduces Bias and Misleads the Crowd
Figure 6.21 Beatles: Tally for First Group
Figure 6.22 Beatles: Random Guesses in the Wild
Figure 6.23 Beatles: Random and Wrong
Figure 6.24 Beatles: Random and Right
Figure 6.25 Beatles: Tally for First Two Groups
Figure 6.26 Beatles: Random and Wrong
Figure 6.27 Beatles: Random and Wrong
Figure 6.28 Beatles: Tally for First Three Groups
Figure 6.29 Beatles: Random and Wrong
Figure 6.30 Beatles: Random and Right
Figure 6.31 Beatles: Tally for First Four Groups
Figure 6.32 Beatles: Tally for All Five Groups
Figure 6.33 Beatles: Correct Answer Emerges from the Crowd
Figure 6.34 Beatles: Biased and Wrong
Figure 6.35 Beatles: Biased and Wrong
Figure 6.36 Beatles: Biased Answer Produces Wrong Crowd Guess
Figure 6.37 Apple: Range of Q4 Earnings Predictions
Figure 6.38 Apple: Diversity Reduces Crowd Error
Figure 6.39 Apple: Biased Estimates Affect Diversity

Chapter 7

Figure 7.1 Mr. Market’s Various Moods
Figure 7.2 Value of an Asset—Primary Components
Figure 7.3 Lack of Diversity and Breakdown of Independence Caused by Mayhem Produces a Mispriced Stock
Figure 7.4 Approaches to Determine Intrinsic Value
Figure 7.5 Distributions of Intrinsic Value Estimates Based on Different Investor Valuation Models
Figure 7.6 Sevcon: Range of Estimated Liquidation Values
Figure 7.7 Intrinsic Value Estimate Before and After Customer Loss
Figure 7.8 Mr. Market Overreacts
Figure 7.9 Domain-Specific Knowledge Is Comprised of Facts and Expertise That Form an Individual’s Processing Model
Figure 7.10 Homemade Electromagnet
Figure 7.11 The Electromagnetic Pull of Market Efficiency
Figure 7.12 Mayhem’s Bias Pulls Stock Price Away from Intrinsic Value
Figure 7.13 Non-Biased Electromagnets Overpower While Bias Weakens and Stock Returns to Its Efficient Price
Figure 7.14 Biased Behavioral Magnet Overpowers Unbiased Electromagnet of Market Efficiency
Figure 7.15 Underpowered Unbiased Electromagnet Cannot Correct Extreme Behavior Pull
Figure 7.16 Unbiased Electromagnet Ultimately Overpowers the Biased Behavioral Magnets and Stock Returns to an Efficient Price
Figure 7.17 Market Efficiency and Behavioral Finance Coexist
Figure 7.18 Apple, Inc.: Price Quote
Figure 7.19 Associated Capital Group: Price Quote
Figure 7.20 Client Invests in Funds
Figure 7.21 Client Sees Fund and Stock Down 22.7%
Figure 7.22 Client Redeems Investment
Figure 7.23 Fama and Shiller Are Both Right!

Chapter 8

Figure 8.1 Dollar General One-Year Price Targets Without Mispricing
Figure 8.2 Dollar General: Variant Perspective Versus Consensus Expectations
Figure 8.3 Variant Perspective Translates to Divergent Estimate for Cash Flows
Figure 8.4 Divergent View of Future Cash Flows Produces Variant Perspective
Figure 8.5 Consensus Expectations and Your Variant Perspective For Future Cash Flows
Figure 8.6 Stock Mispriced Due to Information Not Being Fully Disseminated
Figure 8.7 Absence of Errors Leads to Efficiently Priced Stock
Figure 8.8 Research Process
Figure 8.9 Twitter’s Stock Performance in Reaction to Its Inadvertent First Quarter Earnings Release
Figure 8.10 Stock Mispriced Due to Information Not Being Fully Disseminated
Figure 8.11 Error in Processing Results in Mispriced Stock
Figure 8.12A Dan’s Expected Return from Herbalife Bond Position
Figure 8.12B Dan’s Actual Return from Herbalife Bond Position
Figure 8.13 Investment Time Horizon and Breakeven Point
Figure 8.14 Investment Time Horizon with Extended Breakeven Point
Figure 8.15 John’s Perception of Error by the Consensus
Figure 8.16 Stock Mispricing Caused by Error in Incorporation
Figure 8.17 Requirements for an Efficient Stock Price
Figure 8.18 Stock Performance Heat Map

Chapter 9

Figure 9.1 Consensus Decision Model Distorted by Error in Processing
Figure 9.2 Tesla: Analysts’ One-Year Price Targets
Figure 9.3 Tesla: Consensus Estimate
Figure 9.4 Tesla: Expected Return Implied by Consensus Price Target
Figure 9.5 Tesla: Market Implied Risk of Investing in Stock at $245 per Share
Figure 9.6 Tesla: Outcomes Above Market Price are Uncertain But Not Risky
Figure 9.7 Tesla: Initial Expected Return versus Market Implied Risk
Figure 9.8 Tesla: Stock Price Increase from $245 to $278
Figure 9.9 Tesla: Increase in Price Results in Lower Expected Return and Additional Risk
Figure 9.10 Tesla: Market Implied Risk with Stock Price of $278
Figure 9.11 Tesla: Stock Price Declines from $278 to $245
Figure 9.12 Tesla: Lower Price Produces Higher Expected Return and Lower Market Implied Risk
Figure 9.13 Margin of Safety Equals Expected Return
Figure 9.14 McCormick and Tesla Consensus Estimates of One-Year Price Targets
Figure 9.15 Comparing the Risk of McCormick and Tesla
Figure 9.16 Three Components of Investment Return
Figure 9.17 Expected Rate of Return
Figure 9.18 Error in Estimating Time Horizon
Figure 9.19 Error in Estimating Intrinsic Value
Figure 9.20 The Difference Between Accuracy and Precision
Figure 9.21 Initial Assumptions
Figure 9.22 Research Results in Greater Accuracy
Figure 9.23 Increased Accuracy Reduces Risk
Figure 9.24 Initial Assumptions
Figure 9.25 Your Estimate of Risk
Figure 9.26 Greater Precision Reduces Risk
Figure 9.27 Initial Assumptions
Figure 9.28 Increased Accuracy and Precision Reduce Risk Significantly
Figure 9.29 Risk Reduction from Initial Condition
Figure 9.30 Range of Estimated Time Horizon
Figure 9.31 Implied Risk in Estimated Time Horizon
Figure 9.32 Figure 9.18: replicated
Figure 9.33 Market-implied Risk
Figure 9.34 Normal Versus Skewed Distribution
Figure 9.35 Risk Reduction Due to Skewed Distribution
Figure 9.36 Consensus Implied Risk For Cloverland
Figure 9.37 Helve’s Variant Perspective Results in Lower Risk
Figure 9.38 Heat Map: Risk of Capital Loss
Figure 9.39 Helve’s Variant Perspective Regarding Time Horizon
Figure 9.40 Cloverland: Break-even Investment Time Horizon
Figure 9.41 Heat Map: Risk of Underperformance

Chapter 10

Figure 10.1 An Individual’s Process for Estimating Intrinsic Value
Figure 10.2 Reverse Engineering the Decision-Making Process
Figure 10.3 Schema for a Sundae
Figure 10.4 Bacon Sundae Is Rejected
Figure 10.5 Matrix of Fundamental and Valuation Criteria
Figure 10.6 Dreaming of the Perfect House and the Perfect Investment
Figure 10.7 Schema for Summer House
Figure 10.8 Stated Criteria for Summer House
Figure 10.9 Criteria Parsed into Quantitative and Qualitative
Figure 10.10 Objective Quantitative Criteria Satisfied
Figure 10.11 Objective Versus Subjective Criteria
Figure 10.12 Subjective Criteria Not Satisfied
Figure 10.13 Unstated Criteria Revealed and Included
Figure 10.14 Unstated Criteria Were Not Satisfied
Figure 10.15 Portfolio Manager’s Stated Investment Criteria
Figure 10.16 Parsed Quantitative and Qualitative Criteria
Figure 10.17 Objective Quantitative Criteria Satisfied
Figure 10.18 Objective versus Subjective Criteria
Figure 10.19 Subjective Criteria Were Not Satisfied
Figure 10.20 Unstated Criteria Revealed and Included
Figure 10.21 Unstated Criteria Were Not Satisfied
Figure 10.22 Fundamental and Valuation Investment Criteria
Figure 10.23 Idea Adoption Requires Overcoming Objective and Subjective Obstacles
Figure 10.24 Negative Space and Rubin’s Vase

Chapter 11

Figure 11.1 Lack of Dissemination Results in Mispriced Stock
Figure 11.2 Questions to Achieve the Perfect Pitch
Figure 11.3 The Perfect Pitch for Cloverland
Figure 11.4 The Dimensions of Evidence Quality

Chapter 12

Figure 12.1 Obstacles to Getting the Idea Adopted
Figure 12.2 Typical Overcrowded Slides
Figure 12.3 IEH Corporation’s Hyperboloid Connector
Figure 12.4 Typical Summary Data Slide
Figure 12.5 Variant Perspective for Cloverland
Figure 12.6 Portfolio Manager: “Do I Believe Him?”
Figure 12.7 Portfolio Manager’s “New Analyst” Schema
Figure 12.8 Six Stages of an Initial In-Person Meeting

Pitch the Perfect Investment