Pitch the Perfect Investment: The Essential Guide to Winning on Wall Street

480 Pages·2017·15.96 MB·English

by  Paul D. Sonkin

Pitch the Perfect Investment
Pitch the Perfect Investment
The essenTIal GuIde To WInnInG on Wall sTreeT
Paul d. sonkin and Paul Johnson
Cover image: Ticker tape, Anotonio Petruccelli, Reproduced by permission of Mike
Petruccelli
Cover design: Jennifer Gallagher
Copyright © 2017 by Paul D. Sonkin and Paul Johnson. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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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. |
Identifiers: LCCN 2017013999 (print) | LCCN 2017025132 (ebook) | ISBN
9781119280965 (pdf) | ISBN 9781119280972 (epub) | ISBN 9781119051787
(hardback) | ISBN 9781119280965 (ePDF)
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
Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1
PS dedicates the book to the next generation—Zev, Zoe, and Paris.
PJ dedicates the book to his two near-perfect children, Charlotte and Henry.
Contents
Preface ix
Introduction 1
Part I The PerfeCT InvesTmenT 23
Chapter 1 how to value an Asset 25
Chapter 2 how to value a Business 43
Chapter 3 how to evaluate Competitive Advantage and value Growth 71
Chapter 4 how to Think About a security’s Intrinsic value 127
Chapter 5 how to Think About market efficiency 145
Chapter 6 how to Think About the Wisdom of Crowds 171
Chapter 7 how to Think About Behavioral finance 223
Chapter 8 how to Add value Through research 267
Chapter 9 how to Assess risk 299
Part II The PerfeCT PITCh 337
Chapter 10 how to select a security 339
Chapter 11 how to Organize the Content of the message 371
Chapter 12 how to Deliver the message 395
acknowledgments 431
art acknowledgments 435
about the authors 439
Index 441
vii
Preface
A picture is not thought out and settled beforehand. While it is being done
it changes as one’s thoughts change. And when it is finished, it still goes
on changing, according to the state of mind of whoever is looking at it. A
picture lives a life like a living creature, undergoing the changes imposed
on us by our life from day to day. This is natural enough, as the picture
lives only through the man who is looking at it.
—Pablo Picasso1
T
he quote by Picasso captures how we feel about this book, as our
thoughts changed considerably over the three years it took us to
write it. In the many conversations we had with our patient acqui-
sition editor, Bill Falloon, once again explaining why the book
was going to miss yet another deadline, we reassured him, “You are
going to get a much different, but better book than you initially
signed up for.”
Now that the book is finally finished, we are excited to see what
happens as our creation is “released into the wild.” Like Picasso’s
picture, our book will take on a life of its own as the concepts we
present are assessed and scrutinized, adopted by some and refuted
by others. We know that certain of our ideas will undergo changes
as our readers either build upon or discard and replace them
1 Conversation with Christian Zervos, 1935, reprinted in Picasso on Art, ed. Dore
Ashton (New York: Viking, 1972).
ix
x Preface
through the process of creative destruction.2 We welcome both. It is
our desire to educate and stretch people’s minds in the fields of
security analysis and fundamental investing. We hope that, like
Picasso’s pictures, the book lives a long life through those who are
looking at it.
As Paul S. is fond of saying, “Being listed as a co-author and writ-
ing a book are two completely different things.” While we both have
been listed as co-authors before, this is the first book that we have
actually written. We both had wanted to write a book for years, but
life kept intervening and we never found the time to pursue the
idea. During the summer of 2013, with significant prodding from his
friend Alejandra, Paul S. finally decided to write a book.
Like so many events in life, the spark of this collaboration was
random. On Friday, October 4, 2013, just after the conclusion of
the 23rd annual Graham & Dodd Breakfast at the Pierre Hotel in
New York City, Paul S. and Paul J. were talking when Paul S. men-
tioned that he was planning to write a book. Paul J. asked, “What
is the title of your book?” Paul S. replied, “The Perfect Pitch.” Paul J.
responded, “Funny. I had always planned on writing a book called
The Perfect Investment.” We began emailing each other after returning
to our offices later that morning and quickly discovered that our
books were complementary. While Paul S. was fascinated with the
role pitching played in getting an investment idea adopted, Paul J.
was focused on finding the right idea to pitch. It became increas-
ingly clear that the two books were different sides of the same coin
and obvious that we should combine efforts to write a single book
together.
In addition to our complementary views, we had known each
other for almost 20 years, had similar approaches to investing, and
a lot of mutual respect. Besides, we thought it would be fun to work
together. The book began to take shape over the next several weeks
as we fleshed out the proposal for our publisher and settled on the
title Pitch the Perfect Investment.
The gestation of our friendship began in September 1994 when
Paul S., then a student at Columbia Business School, took Paul J.’s
Security Analysis class. Paul S. and about 20 other students loved
Paul J.’s content and teaching style so much that they persuaded
2 In the words of Paul Samuelson, “Inexact sciences . . . advance funeral by
funeral.”
Preface xi
him to teach a second class the following semester. When Paul S.
approached Paul J. about teaching this class, Paul J. said, “I already
taught you all the material I have.” Paul S. responded, “That’s okay,
just teach the same stuff again.” Of course, Paul J. created new mate-
rial and the class was a smashing success.
Over the following summer, Paul S. offered to help Paul J. with
his Security Analysis class and became his teaching assistant in the
fall of 1995. Then, in the spring of 1996, Paul S. became an adjunct
professor and taught at Columbia Business School for the next 16
years, eventually teaching over 450 students. As of the writing of this
book, Paul J. has been an adjunct professor for 25 years and has
taught over 40 investment courses to more than 2,000 students.
For Paul S., the journey to writing this book began when he
started working as a research analyst for legendary microcap value
investor Chuck Royce after graduating in May 1995. On his first day
at work, he found out abruptly that he was not adequately prepared
for the job. While he felt that he had a pretty good handle on the
mechanics of the research process, he was unequipped to present
the information in a way that would persuade a portfolio manager to
follow his recommendation. He quickly discovered that many of his
classmates were in a similar position. Paul S. remembers a call from
one of his former classmates, who told him, “It’s my first day on the
job and my boss came over to say hello, and see how I was settling
in, then threw an annual report on my desk, said ‘tell me what you
think,’ leaving before I had a chance to ask him anything. What do
I do now?”
To address that deficiency, when Paul S. taught his first class,
Advanced Seminar in Fundamental Research Techniques, in the
spring of 1996, his goal was to teach students the essential skills they
would need to do their job as a securities analyst. He told his stu-
dents on the first day of class, “You go to Apex Technical School to
learn how to weld. This class will teach you how to be a research ana-
lyst. It’s a vocational class that will teach you how to do the job.” Paul
structured his lectures originally to teach fundamental research
techniques, with the course culminating in a final project where
each student gave a 20-minute presentation on a stock they had
worked on during the term. The presentations were painfully bor-
ing, and to Paul, who was diagnosed with attention deficit disorder
at the age of five, the experience of sitting through them was simply
xii Preface
unbearable. Because of his impatience, he interrupted students
after a minute or two into their presentation and started peppering
them with questions.
As a result of this experience, Paul completely inverted the
structure of the course. The final project remained a presenta-
tion, but research was now performed to support the pitch, not
the other way around. Paul figured that if the students could sup-
port and defend their pitch, then it indicated that they had done
an appropriate amount of research. This exercise cemented Paul’s
belief that the pitch is the backbone of any good investment recom-
mendation.
There was a parallel influence for Paul structuring his class this
way. In the fall of 1995, Paul audited Pat Duff’s Advanced Secu-
rity Analysis course,3 in which students were assigned an industry
and required to pitch stocks from that industry to guest portfo-
lio managers Duff invited to class. These portfolio managers, like
legendary investor Dick Gilder, would mercilessly punch holes
in the students’ presentations. Paul adopted this structure in his
Security Analysis class the next time he taught the course. Then,
in the spring of 1999, Paul conceived the idea of melding Duff’s
class with Bruce Greenwald’s Value Investing class4 to create a new
course, which he titled Advanced Seminar in Applied Value Invest-
ing and then taught for the next 13 years. The new course focused
on having the students pitch investment ideas with a value disci-
pline. Applied Value Investing is one of the most popular courses
at Columbia Business School, with multiple sections taught each
semester.
Paul J.’s journey was different. Paul became an adjunct profes-
sor at Columbia Business School in the fall of 1992 on the recom-
mendation of Charlie Wolf, with whom Paul worked at Credit Suisse
First Boston. Charlie had been a tenured professor at Columbia
since 1966, teaching courses on debt markets and credit instru-
ments. Roger Murray, who began teaching Security Analysis at
Columbia when Benjamin Graham retired in 1956, had himself
3 Advanced Security Analysis originally was taught by Jimmy Rogers, then
handed over to Pat Duff, then to John Griffin, and then to David Greenspan.
4 Paul S. was the teaching assistant and graded final papers for Bruce Green-
wald’s Value Investing class for several years and co-taught the class in 1997 with
Paul J. while Bruce was on sabbatical.
Preface xiii
retired in 1978. After several years without offering a course in
security analysis, the Business School asked Charlie to take over
teaching the class. At the age of 51, to learn more about how an
equity analyst did his job, Charlie took a sabbatical year off from
teaching to work as a rookie analyst at First Boston Corp. (which
was eventually acquired by Credit Suisse). Charlie began his Wall
Street career writing research reports on a small technology com-
pany called Apple Computer. He was so enthralled with being a
Wall Street analyst that he gave up his tenure and never returned to
academia. Charlie agreed with the school to teach security analysis
as an adjunct professor, usually in the fall term, and to recruit other
Wall Street analysts to teach the same course in the spring. Charlie
was unable to teach the course in the fall of 1992 and walked across
the hall to Paul’s office to see if he had any interest in teaching the
course for him. The conversation took place in early August and
the fall term was scheduled to start only four weeks later. Although
Paul was amenable to the idea of teaching someday, he was con-
cerned that he would not have enough time to prep for the term or
enough material to fill a semester-long course. Further to the point,
Paul had received his MBA only the spring before and was a little
concerned that he was too inexperienced to teach an investment
course to MBA students at a top-ranked business school. But Char-
lie was persuasive and Paul agreed to teach the class. Paul loved the
experience so much that he continued to teach (off and on) for the
next 25 years.
Paul J.’s interest in writing a book stemmed from his hope of
one day publishing his classroom material, although he recognized
that there was a big difference between creating lecture notes and
writing a thoughtful investment book. Paul knew that the main chal-
lenge would be finding the time to convert his notes into a book
while he pursued his career and raised his family. It took the nudge
from Paul S. in late 2013 to get the ball rolling.
This book ultimately is the product of our frustration. We have
had no book to assign for our courses that covered all of the main topics
that we teach and wanted to rectify the situation. There is The Intel-
ligent Investor by Ben Graham, The Most Important Thing, Illuminated
by Howard Marks, You Can Be a Stock Market Genius by Joel Greenblatt,
pirated copies of Margin of Safety by Seth Klarman, and photocopies
of the Buffett Partnerships letters, but there is no single source of