The Magic Formula to Find Quality Businesses?
My grandmother came to America in 1922 from Russia.
She traveled with her future husband — my grandfather — in steerage.
Steerage was the part of the ship for passengers with the cheapest tickets.
But they both dreamed of a better life in America.
Grandma told me they actually thought the streets were paved with gold.
Reality quickly set in when the ship arrived at Ellis Island in New York Harbor.
Although they had no more than the clothes on their back, the future looked bright.
And my grandparents built a life for themselves and raised three daughters.
My grandparents and their three beautiful daughters. My mom’s on the right in the front row.
Grandma was a no-nonsense person. (I get it from her.)
She would say what she meant and meant what she said…
When I started driving, grandma would call me to drive her around.
She would always apologize for taking me out of my way.
But it was truly my pleasure and honor. Spending time with her was a real treat.
One day, when I was supposed to take her shopping, I lost track of the time.
I pulled up to her apartment building, and she was waiting outside.
The look on her face wasn’t a happy one.
When she got in the car, I made up a silly excuse for my lateness.
She nodded. And I thought she bought my story.
Then, she said something in Yiddish. I asked what it meant.
She translated it into English for me: “Don’t piss on my back and tell me it’s raining.”
Needless to say, that’s the last time I ever tried to pull the wool over grandma’s eyes.
Cut to the Chase
On Wall Street, I ran into a lot of people who weren’t the straightest arrows.
They would substitute facts for opinions.
And when I pressed them on it, they doubled down.
Over time — and after losing a lot of money — I learned how to discern reality from BS.
One of my mentors told me the key to making money in stocks is simple.
All you need to do is buy quality businesses when they trade at bargain prices.
It seemed simple enough, but he didn’t share with me how to identify a quality business.
He told me: “It took me 30 years to figure it out, and I’m not giving you a free pass.”
Now you know why they say that if you want a friend on Wall Street, buy a dog.
So, I went to the bookstore and started reading…
Three of the most popular books on identifying great businesses were:
- In Search of Excellence by Tom Peters and Robert H. Waterman Jr. (1982).
- Built to Last by Jim Collins (1994).
- Good to Great by Jim Collins (2001).
The authors tried to find companies that were great, excellent or enduring.
They looked for qualities that made these businesses leaders in their industries.
And if the reader could mimic them, they would have similar performance.
But such was not the case.
As time went on, the companies the authors highlighted weren’t so great, excellent or enduring.
I later learned that the authors were caught up in the “halo effect.”
Influence and Nonsense
The halo effect is a bias that influences our judgment.
Positive impressions in one area influence our opinion in other areas.
For example, there’s the impression that a good-looking person is also an overall good person.
One really has nothing to do with the other.
But our overall impression is like a halo around other traits.
Another example is how taller presidential candidates usually win over shorter ones.
Taller leaders are usually seen as stronger leaders.
Back in 2009, I spoke with Phil Rosensweig, author of The Halo Effect: … and the Eight Other Business Delusions That Deceive Managers.
After speaking with Phil and reading his book, I understood how the halo effect influenced the authors of the other books I’d read.
A few of the companies that were great, excellent or enduring turned out to be duds.
Three even filed for bankruptcy: Kmart, Wang Labs and Circuit City.
Most of them were mediocre, and only a few were really great.
A McKinsey study in 2017 found out that of the 50 companies showcased in the books, the results were spotty.
Yet many people still follow these books.
They believe the answer to finding great, excellent or enduring companies is in these books.
Real Talk: Finding quality businesses isn’t easy.
Capitalism is brutal. Companies are always looking to capture market share from competitors.
There’s no magic formula. It requires experience, research and luck.
So, in addition to reading pages of reports and filings, I still rely on my network of colleagues.
And I created a three-step filter that I use in Alpha Investor for finding great businesses.
The company has to be in an industry with a tailwind, be run by a rock star CEO and trade at a bargain price.
If I don’t properly identify the first two, the bargain price doesn’t really matter.
And in my next monthly issue, we’ve identified a quality business that leads the industry.
I believe it has one of the strongest monopolies in the world.
Alpha Investors, stay tuned!
And if you’re not part of the family yet, what are you waiting for?
Founder, Real Talk