Drew Strojny

Own stocks you want to own

Fri, 18 Apr 2025 00:00:00 +0000

As an investor, you sometimes end up owning a stock that doesn’t meet your standards. A must haves and nice to haves checklist can help you stay disciplined and avoid this situation. The specifics of the checklist will vary depending on your particular investment strategy. The constraints of your strategy will determine your must haves, while your personal preferences will determine your nice to haves.

My strategy is to identify and own a small number of above average businesses for a decade or more. This approach is tax efficient and allows me to spend my time learning about a few businesses I admire. It’s also less frenetic and stressful, which fits my personality.

My first constraint is owning a small number of businesses (usually 5 - 8). With more invested in each individual business, the cost of failure for a single business is higher. With that in mind, we must own businesses that don’t require debt and preferably have little to no net debt (unencumbered cash minus debt). Debt amplifies poor management decisions and makes a business more susceptible to stress and shocks. Lack of debt acts as a buffer against poor decisions and mitigates stress and shocks. Next, we must own predictable and defensible businesses that operate in a market that is slow to change. Failure rates are high in rapidly changing markets. Lastly, for obvious reasons, we must have honest, capable, shareholder friendly management.

My second constraint is owning above average businesses. An above average business is one that earns high returns on capital employed (ROCE). This could be due to a strong brand, network effects, oligopoly, or some other structural advantage. We must own high ROCE businesses.

High ROCE businesses produce excess cash. Management must deploy this excess cash rationally. A great business can be a poor investment if excess cash is irrationally squandered on acquisitions or failed growth initiatives. Rational means setting a high bar for reinvestment and sending any remaining cash back to shareholders in the form of share repurchases or dividends. A great business without incremental reinvestment opportunities can still be a great investment if management is rational with capital allocation.

The final constraint is time. We want to hold for long periods of time. With a great business, time is on your side. The longer you hold it, the closer your return will match the underlying returns of the business. Therefore, we must have a fair price (as opposed to a great price). If we’re right about the business and hold it long enough, the price paid will become less and less relevant.

Nice to haves are more nuanced and personal. Ideally, they improve the business outlook while making ownership more enjoyable. For me, these nice to haves include: a founder CEO with significant ownership, candid communication with shareholders, an idiosyncratic culture that feels out of step with the industry, little or no stock based compensation, a clear reinvestment runway, high revenue growth, exceptional capital allocation, and a great price. I’ve yet to find a business that has all my must haves and all my nice to haves. The closest I’ve come across is Constellation Software. It’s been easier to instead identify businesses with the must haves: doesn’t require debt (and preferably holds little to no net debt), predictable and defensible while operating in a slow changing market, honest, capable, shareholder friendly management, high returns on capital employed, rational capital allocation, and a fair price.

Finally, a warning. Investors will sometimes compromise on their must haves to reach for appealing nice to have(s). In my case, I’ve compromised on debt and high returns on capital employed (must haves) to chase a great price, revenue growth, and a founder CEO with significant ownership (nice to haves). Undermining your core principles may work out, but it’s undisciplined and unnecessary. Stick to your standards. Own stocks you want to own.

Expected value everywhere

Sat, 27 Jun 2020 00:00:00 +0000

Expected value (EV) is a useful tool. I first discovered EV while learning how to be a better poker player. In poker, you use EV calculations all the time. An easy example is a flush draw. In a game like Texas Hold’em, if you have a flush draw at the start of the hand, your odds of hitting that flush by the end of the hand are roughly 2-to-1 against. You’ll hit the flush about 35% of the time. Let’s say you’re playing against a single player that goes all-in for $20 on the flop, making the pot $100. You can call or fold. Because you know the odds (2-to-1 against hitting your flush), you can use EV to make a better decision. If you think your flush will be the best hand, over the long run (if you played out this same scenario over and over again) you know on average for every three hands played you’ll lose $20 twice, and win $100 once. Therefore, the EV of this call is +$60. In poker, you’re trying to make bets, calls, and raises with positive EV. If you do that over the long term you’ll be a winner.

When making an investment decision, you’re usually trying to accurately predict the future cash flows of the business. Predicting cash flows with precision isn’t easy. There are multiple versions of a possible future that depend on how various uncertain interconnected events unfold. Betting on a single scenario would be ignoring this uncertainty. For a more accurate representation of future cash flows, use EV with simple probability weighted scenarios. Here’s a real example I used in January 2016 while deciding whether or not to increase my investment in Apple Inc. (AAPL) when the stock price was around $100.

2018 earnings scenarios	Probability	Probability weighted
[1] Best case: $12.23	20%	$2.45
[2] Base case: $10.11	70%	$7.08
[3] Worst case: $5.68	10%	$.57
Total (expected value)	-	$10.10

Scenarios predicting calendar 2018, not fiscal 2018.
All scenarios assume 4.75B shares outstanding at the end of 2018.
[1] Best case: $264B in revenue, 22% net income margin.
[2] Base case: $240B in revenue, 20% net income margin.
[3] Worst case: $150B in revenue, 18% net income margin.

When estimating I try to be roughly right instead of exactly wrong. So, instead of building a complex model, I reduced the owner earnings calculation to two key factors: revenue and net income margin. Then, I assigned probability estimates to each scenario based on my best estimate of the likelihood of each possible future. The result was an EV for 2018 owner earnings of $10.10 per share. A 10% return looked like a no brainer for such a great business in the interest rate environment, so I made the investment.

I still use a similar format for all new investments and find it helpful. The key factors change depending on the business, but the core format remains the same. I now use four possible scenarios (best, good, base, worst) instead of three to account for more possibilities. Of course, it’s important to spend time studying the business to ensure your probability scenarios are well informed, and to update them when things change.

When you’re building software, you’re using EV all the time. Most product teams have limited resources and long lists of feature ideas. Keeping proper balance between sustaining product improvements and high impact new initiatives is important. Sustaining improvements help your product deliver incremental value, while new initiatives have the potential to open up new markets or lines of business.

In the new initiatives case, you’re behaving more like a seed stage investor, spreading many smaller bets in the hopes one will payoff big. When it does, you’ll pour more investment into that initiative. But again, you’re limited by resources, so you want to focus on the ideas with the highest EV. First, decide what you are optimizing for. In this case, you want to optimize for impact (higher is better) and time to ship (lower is better). Assign each initiative an impact score and a time to ship score of 1 to 5. For example, Initiative X has a high potential impact (4 out of 5), but will take longer to ship (2 out of 5). Score 6. The highest score is 10. EV rankings help ensure you’re staying objective and sticking with your strategy.

When ranking a list by EV, be sure to score each variable independently. For example, work through your entire list of initiatives and score each initiative on impact, then move on to scoring each initiative on time to ship. To avoid bias, don’t score an entire initiative all at once.

EV isn’t just useful in business. For example, you’re planning a family holiday. As part of the trip, you’d like to expose your children to a different culture while keeping them safe. You’re optimizing for cultural differences and safety. Compile your list of potential destinations, score them, rank them, and make a more informed decision.

When analyzing any decision, first outline the variables you’re optimizing for. Some variables lend themselves to math focused probability based EV calculations (like an earnings estimate) while others work better with a crude scoring system (like a feature list or a family vacation). In either case, EV can help you make better decisions.

Avoiding association bias in business

Sun, 18 Mar 2018 00:00:00 +0000

As humans, we like to associate because our memory uses association to function. This mental shortcut helps us operate more efficiently, but it can be influenced by conditioning. Conditioning comes in two flavors: classical and operant. Classical conditioning is repeated simultaneous exposure to a potent stimuli (like food) and a neutral stimuli (like a ringing bell). The two previously unconnected stimuli quickly become linked in associative memory and elicit an automatic physiological response. Think Pavlov’s dog. Operant conditioning is controlled through rewards and punishments. Think teaching a mouse to navigate a maze using food rewards.

Because associate memory is weaved tightly into how you think, it has a strong influence over your decision making. If you don’t train yourself to acknowledge association bias and conditioning, it could cause you to make bad decisions. Let’s consider some specific examples.

Past success

You and your team make a bold decision to create a unique new product. It’s a smashing success. A few years later, your team comes up with another new product idea, and the similarity to the smashing success is uncanny. Everyone quickly commits, substantial time and money is invested, and the product is launched. This time the product fails miserably. When the new product reminded you of the smashing success, your associative memory immediately went to work. The new product gained instant (but undeserved) credibility.

This new idea really reminds me of our top selling product, so we should make sure we avoid association bias when considering its chances of success.

Competitors

You smartly study your two biggest competitors, who together control 80% of the market. Over time, you start to associate their success with their decisions. After all, they must know what they’re doing right? You soon find yourself copying their features, their product marketing, and their website design.

The new feature they launched looks interesting, but we should take a close look at how it fits with our overall product strategy before rushing to copy it.

Investments

A company pitching to investors or potential acquirers compares themselves to a well-known successful business in an effort to trigger a positive association. “We’re like Amazon for pets!” Why does this work so well? New investment ideas can be complex and overwhelming, so when an easy associative shortcut is dangled in front of us, we tend to grab it.

They do look like YouTube for video games, but we should be careful not to overfit that analogy during our analysis.

Hiring

Hiring is another overwhelming and intimidating mental process. It involves evaluating a variety of disconnected factors and making some educated guesses. Some mistakes have usually been made in the past. In an effort to resolve the strain, we tend to fall back on something associatively comforting, like a great school or a well-known company. A good antidote — develop a weighted scoring system for candidates before you start the hiring process.

She went to Harvard. We should be careful not to overweight her education when comparing her to the other finalists.

Quickly value a home

Sun, 06 Nov 2016 00:00:00 +0000

Buying a home is a big decision and it’s important to separate the financial part of the decision from the emotional part of the decision. Otherwise, strong emotions may trigger confirmation bias around price.

Three methods

There are three generally accepted methods for valuing a home: comparable sales, cost, and cash flow. Comparable sales considers recent similar sales in the area. Cost considers the raw replacement value of the home (what it would cost to build today). Cash flow considers the potential cash flows generated from the home if it was rented for income.

Comparable sales is the weakest of the valuation methods, because it’s strongly correlated with prevailing conditions in a bidders market. A few bad decisions can quickly ratchet up comparable sales estimates to ridiculous levels (see the recent United States housing bubble). It’s best to ignore this method completely or at least discount it heavily.

Cost is a sound approach, but, it assumes the value of the home is directly related to what it costs to build today. This isn’t a problem if you plan to hold the home forever, but if the home is ever sold, the price will likely be determined by a market, and most bidders will not consider the building cost.

Cash flow is the gold standard for valuing any financial asset, and is therefore the best approach. Let’s work through a simple “back of the envelope” calculation for valuing a home with the cash flow method.

Using the cash flow method

First, you need to estimate a conservative rental value for the home. It’s important to consider and adjust for any temporary external factors (like tight rental supply) that may be inflating rental values in the area. Some basic rental searching or a local property rental agency can help you with determining a conservative estimate.

Let’s assume you’ve determined that the home you’d like to buy would conservatively rent for around $2,000 per month. That means you could generate $24,000 per year in revenue from the home. Keep in mind, revenue is not income. Let’s consider the associated expenses:

Mortgage payment
Property tax
Insurance (plus a landlord insurance premium)
Repairs (about 5% of rent)
Property Management (about 10% of rent)

Add up all of the yearly expenses and subtract them from the yearly rental revenue. Now consider the result:

Positive value: You would earn income renting this home.
Negative value: You would lose money renting this home.
Zero: You would break-even renting this home.

The break-even price is important. In fact, it’s worthwhile to calculate the break-even price by adjusting the home price (and consequently the mortgage payment) lower or higher. Once you’ve determined the break-even price, think of any additional cost as an “ownership premium”. For example, you determine the break-even price is $200,000, but the home costs $250,000. Your ownership premium is $50,000. Keep in mind, there is nothing wrong with paying a premium. You may have many good reasons for doing so. But, don’t kid yourself and also say you’re making a good investment.

When is it a good investment?

Let’s do another quick calculation to determine if this home might be a good investment. Remember, for the home to qualify as a good investment, you’d need to have the option to earn income (revenue minus expenses > 0) from renting it.

To calculate the rough leveraged IRR (internal rate of return) on the investment simply divide the income by your down payment. So, if you purchase the home for $200,000, put down 20% ($40,000), and generate income of $5,000, your IRR would be 12.5% ($5,000 / $40,000). Here’s a rough scale for thinking about IRR in a normal interest rate environment:

Home run: 15%+
Very good: 10%+
Average: 5% - 10%
Mediocre: 0 - 5%

This quick approach doesn’t consider potential appreciation in the value of the home, but that’s intentional. Buying a home in the hopes of it appreciating is usually more speculation than investment. It’s much safer to look at any appreciation as icing on your already good investment cake.

But what is it worth?

This method doesn’t give you the exact value of the home. Instead, it focuses on determining if you’re paying a premium or if you’re getting a good potential investment. It’s a calibration exercise that should help you rationally evaluate the financial sense of the deal.

Online everything?

Sun, 13 Mar 2016 00:00:00 +0000

It’s easy for forward thinking technologists to imagine a tech optimized future. We meet our social, travel, and entertainment needs with a VR headset. All our goods are conveniently dropped at our door, and we only leave the house on special occasions via an autonomous car service. Much of this may turn out to be true, but there are some important nuances being glossed over.

Let’s explore online retail as an example. The conventional reasoning goes something like this:

It’s been proven most people like doing almost everything online better than they like doing it offline.
Therefore, in the future, all shopping will be done online.

Let’s tug at the all shopping part. First, we’ll isolate two important sub-categories of shopping: discretionary and non-discretionary. Discretionary includes non-essentials like books, movies, travel. Non-discretionary includes essentials like food, tissues, diapers, and laundry detergent.

Discretionary shopping fits well into the online only paradigm. Especially when it comes to the actual buying step. You may prefer to “showroom” a bit with your discretionary shopping, but actually buying online adds two self reinforcing psychological pleasures to the mix: anticipation combined with occasional surprise (I forgot I ordered that!).

Non-discretionary also fits nicely into the online only paradigm, especially for items that don’t require much thought. Think about tissues, diapers, and laundry detergent. Most of us make some initial choices on these items, and then stick with them for most of our life. This is why brands fight so hard to be front of mind in these categories.

But what about food?

Food is non-discretionary, but it also involves planning, selection, and variety. While most of us are happy to use the same tissues every day of our lives, we don’t expect to eat chicken and green beans for dinner every night.

If you’re a busy professional or a dual income household, you are almost certainly time constrained and looking for optimization in your life. It’s easy for you to stick food in the same category as laundry detergent. Who would waste time planning, shopping for, and cooking food? If you’re in that demographic, you probably love online food shopping services like Instacart and Blue Apron.

But, all modern families are not time constrained and looking to optimize every moment. According to Pew Research, 37% of US households are still single income. Also, all families spend more time with their children than the prior generation. To the disbelief of the busy professional, many of these families may actually enjoy and embrace the experience of selecting food in person and cooking it. The surging popularity of local farmers markets in the US is one example. Another is companies like Whole Foods successfully making the grocery store a destination with in-store dining experiences. Food is uniquely personal and communal, which lends itself nicely to the physical world.

Offline shopping as an experience

This uncovers a broader point: offline shopping is still a form of escapism and entertainment for many, and due to human nature and preferences, it’s likely to stay that way for a very long time. In the future, many will continue to avoid doing all of their shopping online (even while being aware it’s more convenient!), because they relish the opportunity to get out of the house and have an experience in the real world. The trend of making offline retail more of an experience will likely accelerate to capture this segment of the market. Less big box and boring, more beautiful spaces and entertainment.

We shouldn’t assume because most people prefer shopping online for most things, that all (or even most) people will eventually prefer shopping online for all things. There are certain retail categories that don’t fit so cleanly into that paradigm, and most of us prefer to get out of the house from time to time and experience the real world with other people.

Tuning the news

Thu, 25 Feb 2016 00:00:00 +0000

We all feel somewhat responsible for at least being aware of the news. I’m defining news as the noteworthy events unfolding in the world we all live in. News has also become more accessible, resulting in near instant availability for everyone. Each spare moment is ready to be filled with personalized news or updates from your social network. This deluge of information is wonderful in many ways, but if you fail to apply any tuning, it can reinforce narrow viewpoints and increase your overall stress and anxiety.

Amplification

News is amplified to grab your attention. Most daily events unfolding in our world aren’t especially shocking, but the news media is constantly digging to find a shocking needle in the mundane haystack. Even when the stories themselves are less exciting, they are usually packaged with a shocking headline to grab your attention. To stay rational, consciously de-amplify.

Bold predictions

News is filled with bold and usually dramatic predictions about the future. A rational and accurate judgement about future events requires a more nuanced probability based approach, which isn’t nearly as exciting. Ratings driven media, a public starved for drama, and over-confident pundits form a symbiotic relationship and churn out bold (but usually inaccurate) predictions. To make more accurate predictions, use a Bayesian probability based approach.

Overfitting analogies

We know—from many case studies—that overfitting the most superficially applicable analogy to current problems is a common source of error.

— Expert Political Judgment, Philip Tetlock

If you’re paying attention, you’ll notice this showing up everywhere. Whenever a big news story breaks, the media quickly searches for an applicable analogy from our past. As humans, we have a strong desire to find an analogy between the past to the present, but we unfortunately usually do it haphazardly. We’re much too quick to ignore the subtle but very important differences. Be extra careful not to overfit loosely applied analogies.

Source diversity

Our sources of news usually align closely with our political preferences and our general interests. Unfortunately, if we never read outside these sources, we may end up in a warm bath of self delusion.

If you’re politically conservative, read the New York Times. If you’re politically liberal, read the Wall Street Journal.
If you invest in a company, find some critics and follow them. Expose yourself to dissenting opinions.

This isn’t psychologically pleasant. It’s actually very uncomfortable. If you try it, you’ll notice consistent and strong feelings of reluctance. We feel much better when surrounded by affirming friends and opinions. We tend to be dismissive, angry, and discerning when presented with dissonant evidence.

Because it’s unpleasant, it’s even more important to actively seek out disconfirming evidence. Otherwise, you’ll naturally avoid it and end up with a narrow view of the subject.