Brian Feroldi (03:13):
In fact, I’m a firm believer that what you do with your personal finances is at least 10 times more important than what you do with your investing finances. So when I say financial wellness, I think it’s about thinking of your entire financial picture. And that includes, how much money do you make? How much of your expenses? Do you know what those numbers are? Is your personal balance sheet filled with cash and assets and devoid of debt? Do you have a will? Do you have insurance? Do you have an escape plan? And yes, do you have your investments optimized for long-term growth? Thinking about all of those things collectively to me is financial wellness.

Trey Lockerbie (03:53):
I love that. Yeah, when you think about wellness, I think of it like a spectrum, as you said, where there’s not anyone panacea. So just YOLO-ing and meme stocks shouldn’t be the panacea that gets you to financial freedom. You’re talking about that blocking and tackling that foundation and setting the table of sorts for success. So maybe I have to ask you your own personal journey to discovering this for yourself. How did you arrive at this mission statement that you’ve come up with?

Brian Feroldi (04:22):
My natural inclination is just to be a saver. I was just born that way. And I think some people are just born natural savers and others are born natural spenders. I was just blessed for, I don’t know why to always have that bent in me to save money. With that basic foundation, when I graduated college, I didn’t know much about money at all. I was taught, and I say that with air quotes, the same thing that most Americans are taught about money in school, nothing, nothing at all.

Brian Feroldi (04:56):
The most important money lessons that I learned were learned mostly by observing my parents who were my financial role models. And they never sat me down and taught me lessons, but they themselves were pretty good stewards of money. They always had money coming in. They always had a savings rate. They weren’t flashy with their money, by any sense. So from that just pure osmosis, I picked up those habits. Plus, I think, it was just genetically programmed in me to be that way.

Brian Feroldi (05:23):
When I graduated college, my dad handed me the book, Rich Dad Poor Dad, which was the first time I ever read a book that talked about the basic principles of money, which is everybody’s in business for themselves. The rich don’t work for money. Financial education is extremely important. You can become financially independent by saving and investing diligently. I don’t agree with everything that’s covered in that book by a long shot, but I will forever be in debt to that book because it kickstarted an absolute love of all things related to personal finance money, and investing.

Brian Feroldi (05:55):
And from there, I just went on a never-ending binge to consume the highest quality financial content that I could find. And I just love everything about money, investing, and personal finance. And money is one of the two subjects that affects every area of your life, whether you want it to or not. The other is your health. And despite it affecting so much about your life, it’s largely a taboo subject. It’s something that people are uncomfortable talking to with each other, which is just crazy to me. They would be like, “What kind of exercise routine do you do?” If that was like a taboo topic, or what food are you eating tonight?

Brian Feroldi (06:32):
But money is incredibly important. A lot of people are naturally programmed to do money the wrong way. We’re programmed to be consumers to go out and to buy things. And we compare ourselves to others. So it’s really easy to do the wrong thing with your money. And since my passion is researching and learning about money myself, I’m a big fan of spreading that knowledge to other people.

Trey Lockerbie (06:55):
We have in common actually, Rich Dad Poor Dad was the seminal book for me as well that kick-started my interest in all of this as well. And I was a musician at the time and I went to an event where they had me fill out a retirement calculator. I couldn’t even start the page because my income was so inconsistent. In any way, one concept you mentioned there that I wanted to touch on was the idea of debt and maybe, more importantly, the idea of manageable debt potentially.

Trey Lockerbie (07:23):
So one concept I’ve struggled with is the idea of zero debt. Since I have a mortgage and a car loan, for example. So I know there are folks like Dave Ramsey, who are obviously evangelists of living a debt-free life, paying down debt before you do anything else. But the rub for me is that, like you said, the entire economy is built on credit. So if you want to save up to buy a home, you have to rent somewhere in the meantime. In order to rent, you have to have a good credit score typically, and to have a good credit score, you have to have some credit lines open, et cetera. So I guess what I’m curious to hear your thoughts on what’s your opinion on debt? And do you believe in manageable debt?

Brian Feroldi (08:04):
Overall, I recognize that debt is just a fact of life for most people. And when it comes to your credit score, I myself use credit cards. I love credit cards. They make paying convenience. You get perks for having them, but I pay my credit cards off every single month and always have, and always will. And when it comes to things like mortgages, or student loans, or auto loans, I recognize that those things are a tool that people use to get things that they want when they don’t have the capital to do so.

Brian Feroldi (08:37):
But overall, my general philosophy is more closely aligned to Dave’s than anything else. I’m a big believer in eliminating all your debt, including a mortgage. I recognize that that’s not always mathematically. The smartest thing to do, especially when interest rates are 3% or even below, the math clearly says, leverage your mortgage to the hill and invest that money and pay and pocket the spread. Mathematically, that makes a ton of sense. So it doesn’t make sense to pay off your mortgage early if you’re just looking at the numbers.

Brian Feroldi (09:11):
However, the numbers and the emotions that you’re going to live through are just two different things. The reason I’m a big fan of paying down your mortgage is because for most people, a mortgage is their largest monthly expense, and it’s a fixed monthly expense. Meaning, it doesn’t matter what’s happening in your personal life, that is an expense that has to be paid and serviced monthly. By paying off your mortgage early, you are permanently reducing your largest fixed expense, permanently. You are making your future self more anti-fragile because you’re lowering your fixed costs forever. So that gives you more flexibility down the road to do what you want with your money.

Brian Feroldi (09:52):
So again, financially, I understand a lot of people say I’m never paying off my mortgage, especially when interest rates are this low. For me, I accept the fact that by paying off your mortgage early, it is dumb mathematically, but I think it’s incredibly smart emotionally.

Trey Lockerbie (10:07):
I like that. I think a lot of people fail to recognize also the option to pay double principle every month to help expedite that payment of your mortgage, and also reducing your interest by typically half almost by doing that. And that’s one of those things. There’s little tricks in life that I feel like not enough people know about when it comes to financial wellness.

Brian Feroldi (10:27):
One downside to paying off your mortgage early by doing it that way is once the money is in the mortgage company, you can’t ever get it out. So one other idea is to take that double principle that you’ve made and put it into bonds, or CDs, or a checking account, or something like that. And continually build up that amount until you can wipe out the mortgage in one go. That way, if you need access to that money beforehand, you can still have emergency access to it.

Brian Feroldi (10:53):
Another idea is to take that money and invest it in the stock market. And once that account balance is bigger than your mortgage, then say, “Okay, that’s it. I’m switching it and paying it off.” So there are numerous ways to do it that still give you flexibility. But overall, I think that if you had a paid-off mortgage, you’ll just live a happier financial life, and if you have one.

Trey Lockerbie (11:12):
I love it. And let’s talk about the stock market. You have developed an investing checklist and it makes sense to use a checklist to enter any investment. It’s one of those things, in my opinion, that seems to be simple, but not easy to actually be disciplined enough to follow through every time. I’d love for you to walk us through your investment checklist. And also maybe explain to us how you’ve adopted each step along the way.

Brian Feroldi (11:38):
So I’ve been buying and selling stocks for more than 15 years. And I use the word buying and selling stocks specifically because I would say I’ve only been investing for about 13 years. The first few years of me having money in the market, I had no idea what I was doing and I made every mistake that you can possibly make with investing. So I’ve learned by consistently losing money what not to do. So I know how painful those lessons can be.

Brian Feroldi (12:06):
About 11 years ago, 12 years ago, I became a paying member of The Motley Fool and through interacting with them, my financial and investing knowledge just really skyrocketed. And Motley Fool has discussion boards that are for paying members only. And on there is just incredible information that other members who have been investing for long periods of time freely post. And it’s just unbelievable the knowledge that you can soak up simply by learning from other investors that have been doing this for a long time.

Brian Feroldi (12:40):
Now, once you become a member like I did, you have dozens if not hundreds of stock ideas that are thrown at you at any given time. And I just became overwhelmed with how do I keep track of what I’m actually interested in? And I was trying to do all this in my head. I’d be like, “Well, this company is growing fast, but this other one has a bigger addressable market opportunity. And this other one is small, but I like the CEO of this other one better. Which do I buy?” And it just became chaos trying to manage all this in my head. I finally became smart enough to write down the things that I’m looking for in an investment and write down the things that I’m trying to avoid in an investment.

Brian Feroldi (13:21):
And over time, thanks to a feedback from other investors, it evolves into the checklist that exists today. And just to give you a quick overview of the checklist it spits out a score from zero to 100, and I have a number of different categories. And each category has a certain amount of points assigned to it. And I take any stock that I’ve never heard of before. And I go top to bottom on my checklist and I’m looking at the financials. I’m judging the moat, I’m assessing the potential of the business.

Brian Feroldi (13:50):
I’m thinking about the dynamics between the company and its customer. I’m asking if revenue is recurring and high margin, who’s running the company, do they have skin in the game, et cetera. And then once I get a positive score, then I go through the risks section and I subtract points for things that I don’t like. For example, I don’t like it when a company gets its revenue from just a few customers, that’s called customer concentration. I don’t like it when a company doles out stock options and dilutes investors seriously over long periods of time.

Brian Feroldi (14:22):
So I have a list of attributes that I’m looking for. I have a list of attributes that I want to avoid. And by taking companies through this consistently, it spits out a score on the other side that tells me whether a stock meets the majority of the criteria I’m looking for, or I should just be avoided. From there, I would take the highest-scoring companies, which to me are the highest quality companies that are on the market. And I try to get them into my portfolio at an advantageous crisis. The latter is hard to do and requires a whole bunch of nuance, but that’s my general philosophy on investing.

Trey Lockerbie (14:57):
Well, you mentioned they’re scoring a competitive moat, which is obviously a very qualitative element of a stock. So I’m really interested in that. How do you go about quantifying something qualitative like that?

Brian Feroldi (15:10):
A whole bunch of things in investing are just qualitative. It’s a judgment. It’s something that you’re going to have to just get a feel for. For example, how wide is Apple’s moat? Pretty wide. Why is it wide? Well, you could argue that there are network effects amongst their users. You could argue that there are switching costs once you get used to the phone, you could argue that they have a durable cost advantage due to their size and their scale. You could argue that they have a very strong brand name. And all of those things are working together to give Apple a moat.

Brian Feroldi (15:41):
But to your point, how do you take that and you convert that into a number? That’s what my system attempts to do. I know going in that is just the limitation of my system. In fact, if you took my exact system and use the same stock to two different people, the scores would be different because we’re judging from different perspectives. I’m okay with that and I accept that that is a reality of my system. But as long as I am scoring things consistently amongst companies, I’m pretty happy with the final output. But to your point, there is absolutely a ton of subjectivity here.

Trey Lockerbie (16:16):
I’m also curious if you are updating this score on a regular basis with companies. Obviously, as new earnings come out or new news comes out, are you rerunning it, the company through the mill and spitting out a new number on a quarterly basis, or something like that?

Brian Feroldi (16:30):
Very few quarterly reports will significantly change a company’s number, that’s by design. I’ve set it up so that these scores stay relatively consistent over a period of time. But investing is dynamic. There is news that comes out that significantly changes the investability of a company over time. I’m generally putting in a lot of work up front whenever I’m thinking about making an investment and steadily updating the score every six months, year, or even two years. But if I find a company that scores extremely well on my checklist, which for me, that zero to 100 scores, any company that scores over 80, that’s a very, very good score.

Brian Feroldi (17:09):
The chances that that number is going to fall precipitously is actually pretty low. But again, I think the value of my checklist isn’t necessarily the output. It’s not exactly the score. The real value is forcing yourself to go through a consistent process, because what you learn about a company along the way is far more valuable than just saying, “Oh, this company is at 75 versus these other ones at 77. Therefore, the 77 has an automatic buy. It’s about the process of learning and consistently going for this with each company.

Trey Lockerbie (17:41):
I’m also wondering how you distilled down from this amazingly wide universe of stocks, to begin with. Especially for those who maybe have a full-time job they don’t have all day every day to just pick through stocks. How do you filter down into a reasonable amount of stocks to begin investigating? Do you have certain sectors or industries that you think are your circles of competence and you start there? Walk us through that.

Brian Feroldi (18:06):
Yeah. In general, if you’re going to be an individual stock picker, one of the trade-offs that you’re making is it’s a time-intensive process. So if doing this process sounds like torture to you, just index and call it a day. My system is designed because I love everything about investing. I love it when I find a company that I’ve never heard of before, and I get to research it. That process actually makes me happy. So that would be a thing one that I would say.

Brian Feroldi (18:34):
The way it filtered down is I have a few resources that generally feed me stock ideas, The Motley Fool being one. There’s some people that I follow on Twitter, for example. And I just keep an ever-growing, ever-expanding watch list of ideas. From there, I tend to focus most of my time and effort on two sectors of the market, healthcare, and technology. And just the dynamics of those two sectors, they tend to score the best on my checklist.

Brian Feroldi (19:02):
So if you pitched me a company and said, “Hey, this is an oil and gas company, I can almost immediately dismiss it as an idea, that is just outside my circle of competence. But by taking any company through a few simple checks upfront, I can tell if I want to research it further. For example, one simple check that I do with every stock is to just see how the stock has done since it came public. If a company since it came public is beating the market substantially, that’s a really good sign, in my opinion.

Brian Feroldi (19:33):
I think that winners tend to keep on winning and the losers tend to keep on losing, plenty of exceptions, of course. However, if you give me a stock, the very first thing I do is I just throw it into a chart and just say, is this stock beating the market since IPO and over the last five years? If yes, that automatically takes it to further consideration. If it’s horrifically loss to the market, I would just automatically pass.

Brian Feroldi (19:58):
So I do have a couple of filters like that separate the wheat from the chaff initially. From there, I will do the work and put it through my research process, and anything that spits out a very low score I just dismiss forever. So it’s just a process of finding a few trusted sources to come up with ideas, vetting those sources consistently, and then putting out a consistent list of companies that score very well, and then focus my time attention on them.

Trey Lockerbie (20:22):
I think I’m a little behind on this term. I know I’ve heard it before, and I’ve heard you mentioned that, and it’s just finally stuck with me. But it’s this idea of being a GARP investor, G-A-R-P, which is an acronym obviously for growth at a reasonable price. And the key is understanding what reasonable means. So that said, I noticed that you didn’t really mention valuation as part of your checklist, although it might be in there. I’m curious how much you think investors should weigh valuation into their investment decisions.

Brian Feroldi (20:55):
Valuation is an extremely tricky subject to really master because if you learn anything about valuation, it just makes sense. What’s the thing we’re all taught by watching Warren Buffet? You want to buy a dollar for 80 cents, or 60 cents, or 50 cents, that is all smart investing. And if you are the type of investor that puts valuation first, you are just never going to buy the best growth stocks on the market. Because the best of the growth stocks in the market are almost always, “Insanely overvalued,” the entire way up.

Brian Feroldi (21:31):
If you look back on the history of some of the greatest performing stocks of the last 20 years, your Amazon’s, your Netflix is, your market access is, they have historically traded at very high valuation multiples even 20 years ago. And yet if you bought them 20 years ago and held, even if you paid a very high valuation multiple, you have significantly outperformed the market.

Brian Feroldi (21:54):
How can that be? Well, the greatest growth stocks can grow for a far longer time period than anyone would possibly give them credit for. Amazon came public 24 years ago, and it’s consistently put up double-digit growth that entire time. And yet in 2020, Amazon grew another 40%. If you were to run the clock to 2000 or 1999 and put that into an Excel spreadsheet, it would laugh at you. It would be like, “What crazy assumptions are you putting in here? That this company’s going to grow for 20 years and then grow another 40%.”

Brian Feroldi (22:30):
But that’s what’s happened. Why? Because Amazon is one of the highest quality growth companies in the history of the stock market. So when I’ve learned things like that, I have learned to de-emphasize valuation. That doesn’t mean I don’t look at it, but I’ve learned to seriously de-emphasize it. And it also depends on just the stage and nature of a company.

Brian Feroldi (22:53):
If I find a company that is worth $1 billion today, and I do the work, and I say, I believe that this could be a $20 billion company someday. I’m just going to buy it. I don’t really care about the valuation because if the market cap is one billion and I think it could literally be a 20 bagger in a decade or so, the valuation I paid, it doesn’t matter. What matters is, am I right? Or am I wrong? If that company goes up to 20x in value, the initial valuation I pay will be irrelevant.

Brian Feroldi (23:21):
On the flip side, if you find a company that is big, mature, and much slower growing, then valuation really matters. So if you are going to buy a Microsoft today, a Procter & Gamble today, a Coca-Cola today, I would seriously emphasize valuation because their future is so predictable and so known. But if you found a dynamic high-growth company that was trading at a $1 billion valuation, I would deemphasize valuation. So it’s always about keeping it in mind, but knowing when to emphasize it and when to ignore it.

Trey Lockerbie (23:54):
A couple of ideas come to mind from what you just said, one of which is position sizing. So from what I’ve heard about your style, it’s very reminiscent of actually Tom Gayner, who we’ve had on the show. And it actually sounds similar to even Warren Buffett’s personal portfolio. By that, I mean, it’s pretty diversified and the position sizes are fairly small. Walk us through how you think about position sizing.

Brian Feroldi (24:16):
In general, I am a big fan of diversification. I own roughly 70 stocks or so. And when I am interested in building a new position in a company, the first thing I ask is what is the risk-reward ratio here? If the company could be a 10 plus bagger, as I said, I deemphasize valuation, but I’m going to build into that position very slowly because the odds that I’m wrong are really high. If a company is at high risk and high growth, the odds of that company flaming out are really high.

Brian Feroldi (24:54):
So I would scale into it by using 0.5% increments. So I would devote 0.5% of my portfolio into that stock on day one. Then I would watch it. If the company was executing and the thesis was playing out, I would be happy to add to that company again, and again, and again in 0.5% increments over time, even if the price was higher. Because I care about the long-term potential of the business and the business executing far more than I do about paying the perfect price to get in.

Brian Feroldi (25:30):
So that’s how I would build a position if it was a very risky, very volatile company. If it was a much more stable, mature, predictable, profitable company, I would be more willing to take a larger position into that company upfront. So a company that I really liked, that’s very big is Adobe Systems, the software company that’s been around for decades. It checks so many boxes in what I look for in an investment. But that company is worth over $200 billion today.

Brian Feroldi (25:58):
So if I was going to build a position in that company today, given how mature and how high quality it is, I would be more willing to devote a large portion of my portfolio to that company on day one. So maybe I would build in 1% increments at a faster clip.

Brian Feroldi (26:12):
Now once a company hits 3% of my portfolio, either from me building the position with fresh capital or from it just growing, I stop, I don’t add any more. At that point, it is up to the company to do the rest of the heavy lifting for me. So if you look at my portfolio today, my biggest positions are companies like Mercado Libre, or Tesla, or Amazon, or DocuSign. And I didn’t go out and say to myself, I want these to be my biggest positions. I bought them slowly and through sheer price appreciation, they became my biggest position. So I don’t attempt to concentrate my portfolio, I let the market concentrate my portfolio for me.

Trey Lockerbie (26:58):
I love that. You mentioned Amazon a little bit ago, and I know that optionality plays a big role into your investment checklist. And again, it’s one of those seemingly qualitative metrics. You’ve also said that a business’s optionality is very underrated. So I want to explore it a little bit more. How do you think about the optionality of a company?

Brian Feroldi (27:18):
In general, when I think of the word optionality, I think it’s an ability of a company to produce new products or new services that open up new revenue opportunities for the company over time and expand its total addressable market opportunity. You just called out one of the most optionable companies of all time, Amazon. When Amazon first came out, they sold books. What do they sell today? Everything including computer services through Amazon Web Services. The number of businesses that Amazon has entered and successfully grown in over the last 25 years is just astounding. So that to me is a classic example of optionality.

Brian Feroldi (27:59):
And when you’re thinking about that in real-time and asking yourself how optionable did I think this business is, there’s a couple of things that you can look at. The first would just be the company’s own history. If you were investing in Amazon in 2005, you can look back and said, “Wow.” They started out in books, then they went to CDs, then they went into movies. Now they’re getting into groceries and they’re succeeding. They have a history of entering new markets, and they have a history of launching new products and services. If a company has established a history of rolling out new products and services, that’s a really good indication that they’re going to continue doing so into the future.

Brian Feroldi (28:38):
Another thing you can just think about is the very dynamics of the business itself. Obviously, if you’re an e-commerce company, that’s selling things online, it doesn’t take a tremendous amount of imagination to be like, what other things could they sell online down the road. Other businesses, it can be harder to see that that optionality. But in general, I think, if you look at the company’s own history and check to see if they have a history of launching new products and services, that’s a really good indication that they’re going to launch even more products and services into the future.

Trey Lockerbie (29:08):
That begs the question of the leadership of a company because I imagine that’s something that you look at as well and the checklist. How much weight do you put into who’s actually running the company?

Brian Feroldi (29:18):
The manager and the CEO of a company are really important as is the culture of the company and the employees. When you look over long periods of time, it’s really the decisions of management teams and the employees that lead to the execution of the business. The execution drives the financial results and the financial results drive the stock price. So the management team and the culture are really important. On my 100 point scale, I assign about 14 points in total to the management team.

Brian Feroldi (29:45):
When it comes to judging a management team, as an outsider, you can’t call these people on the phone. You can’t go and visit the company and talk to employees. Some investors do that. So you have to look for shortcuts that indicate that a company has a great management team. A couple of ways that I do that is by just asking, “Well, who is the CEO of the company?” If the CEO is the founder, that’s a tremendous sign to me because the founder of a business typically cares much more about the long-term viability of the company than they do anything else.

Brian Feroldi (30:18):
It is nearly impossible to found a company, get it all the way to the public markets and not to be insanely rich. Everyone that has done that successfully is worth millions or tens of millions of dollars. At that point, they could retire. They could stop working and live on a beach for the rest of the life. If they are choosing to remain the CEO of that company, why would they do that? They must like running the company more than they just want the money from running the company. So if a company is founder-led, that is a really good sign that I have good points too.

Brian Feroldi (30:52):
If it can’t be the founder, I want to see that the CEO has been at that company for 10 or 20 years, ideally starting at the bottom ranks and working their way up to the business. So that is another really good sign because again, that person has likely poured their heart and soul into the business. They likely have friends and family that work at the business with them, and they really care about the long-term health of the business, not necessarily short-term factors.

Brian Feroldi (31:18):
On the flip side, I don’t like to invest in companies where the CEO is just hired three months ago from some other company, and they are put in there to focus on earnings or improve operations. That to me is a bad sign. So just the history of the CEO is something I look at. Another thing to check is just how much of the stock do they own. This is just called skin in the game. You want to know that if the stock goes down, you as a shareholder are going to be hurt, but the CEO is going to be hurt way more than you are. So you want them to own a significant amount of stock.

Brian Feroldi (31:48):
The third thing would be the Glassdoor ratings. So Glassdoor is an online tool that you can go to just see what reviews do the employees give. They can rate the CEO anonymously. If that CEO gets really high ratings and employees seem to really like looking for the company, that’s a great sign. If employees go on there and say, our business is going down, I hate the CEO, and the company gets two stars out of five, that’s a really bad sign that they’re going to have a hard time attracting talent.

Brian Feroldi (32:16):
Finally, I look at the mission statement of the company, how good is the company at communicating its mission to both employees and to investors. And then lastly, I look at the company’s financial performance. Are they consistently meeting their targets? Are they consistently exceeding Wall Street’s estimates, Wall Street’s expectations? That tells me that they understand how Wall Street works. And that’s a really good sign. So when you look at all five of those factors together, I think they give you a really good sense of is the person that’s running this company is in it for the long haul, or are they just in it for the short-term gain?

Trey Lockerbie (32:50):
Another thing I’m curious about is your position sizing going to 3% or more. And it begs the question of when to sell, which is a theme I’ve been wrestling with also lately because there seem to be two schools of thought. One is the market is inefficient. And if you have high conviction in the company, you should just keep building your position as the price becomes more and more attractive. On the flip side, there’s also this philosophy that you should cut your losers very early and only add to your winners. So how do you think about selling a stock?

Brian Feroldi (33:24):
Every big investment mistake that I’ve ever made all have the same word in common, sell. Every single time that I’ve sold a company that has gone on to 5x, or 10x, or 20x, it has cost me way more and lost upside than I gained from selling a stock that then went down a further 50%. Because I’ve done that several times and I know people that have sold companies like Netflix, and that was literally a multi-million dollar mistake. When I see things like that, and I’ve learned that the hard way, I have become reluctant to sell. I have a bias towards holding and a bias against selling. So that is my general overview of selling.

Brian Feroldi (34:10):
However, that doesn’t mean that I never sell. And there are 11 reasons that I will sell a company. I’ll tick through them really fast. Number one is the most common and the most important, I was wrong. I thought blank about a company. I thought the thesis for owning a company was A, it turns out that thesis was wrong. The company didn’t execute like I planned on it. If I’m wrong about a company, I will tuck my tail between high legs, admit defeat, sell, and move on.

Brian Feroldi (34:40):
Number two, if there’s accounting irregularities, if I can’t trust the numbers, you’re dead to me forever. Why would I bother with your stock? Number three, if a company makes a massive acquisition that I don’t like, and relative size is important here. So if Google spends $5 billion to buy a company, it’s irrelevant. Google is a $1 trillion company, a $5 billion investment is no big deal. If a $5 billion company acquires another $5 billion company, that’s a big deal. And if I don’t like that acquisition, that could be thesis-changing. So I will sell if I disagree.

Brian Feroldi (35:16):
Number four would be the thesis is complete and there’s no compelling second act. In other words, the company executed against its original mission or its original practical line, and it hasn’t developed a second business that will take growth to the next level. So if a company’s organic growth rate all of a sudden starts to fall below say 5% because it’s just running out of room to grow. I have no problem declaring victory, selling that company, and buying something else.

Brian Feroldi (35:43):
Number five, if there’s a mass exodus of management or Glassdoor rating plunge, AKA, the culture is really deteriorating, I’ll sell. Number six, if the company is too large for me, I’ll sell. So for example, if a really high-quality business such as MasterCard or Amazon became 15% of my net worth, I would say that’s too much and I’ll start to trim that position.

Brian Feroldi (36:06):
Number seven, if the company’s valuation is extreme compared to its opportunity. This is a really tricky one. If I think the best-case scenario for a company is it grows to be a $200 billion company, and right now that company is trading at a very high valuation and it’s worth 100 billion, that is a whole lot of risk I’m taking on for only a potential double. In that case, I would be willing to trim the company because I don’t think the gains are justifying the risks that I’m taking on.

Brian Feroldi (36:34):
Number eight, if I just lost interest in the business, I no longer want to follow it, I’ll sell. Number nine, if it gets acquired, I’ll sell. Number 10, if I need the money for my personal life, AKA, the reason we invest in the first place, I will sell. And then finally for tax-loss purposes. If I’m down big on stock and I just want to take the tax loss on it, I’ll sell.

Trey Lockerbie (36:58):
Fantastic. I’m also curious about what you said you’re a saver early on. So I’m curious about your position of cash and what that typically looks like compared to your portfolio. Do you keep that in any relative balance that you watch closely or do you not mind so much how much cash is sitting on any given time?

Brian Feroldi (37:17):
Yeah, so I keep two cash balances and I keep them separate on purpose. So the first cash balance I keep is just my personal emergency fund. That is six months of expenses that I just keep set aside in a boring checking or savings account. Yes, it’s paying me nothing to keep in there, but that’s okay. The point of that capital isn’t to earn a return, the point of that capital is to help me sleep at night. In case we had serious health setbacks, or career setbacks, or something like that, I like knowing that that capital is there to get me through a six-month period.

Brian Feroldi (37:53):
So I don’t consider that part. I don’t consider that capital investible. In my portfolio, I typically keep my cash balance between 0.5% and 10% depending on what kind of opportunities I’m finding in the market and just the general valuations that I see. So if I’ve gone through a period where some of my companies have gotten bought out, or I was just wrong, I have no problem selling those companies and then building up my cash position. And if I’m not fine, anything that’s screaming at me that you must buy this today, I have no problem with cash, just sitting there and waiting.

Brian Feroldi (38:26):
But overall, I like to keep the vast majority of my money that’s for investments invested, even when markets are at all-time highs because the market can continue going up and generally it does sell. So I don’t keep a huge cash balance, but I do keep some set aside for opportunities.

Trey Lockerbie (38:42):
That emergency fund piece is incredibly prudent. And I know it’s a very personal thing and very relative. It reminds me a little bit of someone like Bill Gates at Microsoft who wanted to have cash reserves that covered payroll for an entire year. Obviously a very conservative approach. Maybe not so much when you’re a company like Microsoft that’s a money generating machine, but I digress. I’m curious how you think about the emergency fund a little bit further. Is it for you a six-month timeline of covering expenses or how do you measure out what that fund should be?

Brian Feroldi (39:14):
Yeah. I have a formula that I created that’s up on my Twitter account. In general, I think, it should be somewhere between three and six months for the average person. And that really depends on your personal situation. If you have a very predictable job and you have no dependents in any way, and you could easily get another job, and if you lost yours for whatever reason, I would say a three-month emergency fund is perfectly fine.

Brian Feroldi (39:39):
On the flip side, if you are working in a volatile industry, that’s on the decline. If it would be extremely hard for you to get another job if your house has one source of income and you have several kids that you need to support, even if something disastrous has happened, I would go much more towards a six-month emergency fund. Personally, I am a conservative person financially, especially with my personal finances for that I keep closer to a six months emergency fund that just helps me feel good and sleep good at night.

Trey Lockerbie (40:09):
You strike me as someone who has taken the entire journey, maybe not the entire journey, I shouldn’t say that much, but you’ve developed your own authentic style after studying all of the classic texts. And it reminds me of when I went to the Van Gogh Museum one time, something that stuck with me there was that Van Gogh started out painting landscapes and still lifes. And when I looked at those landscapes and still lifes they were the best I’ve ever seen. I mean, they were literally like as good or better as any other artists. And it’s where you start out or where he started out as an artist. And then he just ventured off and became Van Gogh and did his own style.

Trey Lockerbie (40:51):
I think it’s important for investors to do that for themselves and not just stick to some classic text, just because it says so. And I’m saying all this because Buffet himself has evolved to some degree, but he has said that he still like 85% Benjamin Graham and 15% Phil Fisher. So the question that’s coming to my mind is looking at your style today and how quantitative you are, could you break it down in a similar way saying, well, I’m this, I’m that, and now here’s where I’m sitting from all the people I’ve studied along the way?

Brian Feroldi (41:23):
I have been influenced by dozens of investors along the way, but if you forced me to say, okay, who are the people that have influenced your style the most? I can name three. Number one would be David Gardner, who is the co-founder of The Motley Fool. His investing style is called rule-breaking, where he essentially looks for fast-growing high-quality companies that could literally be 10, 50, 100x. Buy them early, hold them longer than anybody else. And you’ll swing and miss a whole ton.

Brian Feroldi (41:53):
But on the off chance you find the next Amazon or the find the next Netflix, which he did in 1997 and 2002, respectively, or 2003, whenever Netflix came to came public, the gains from those stock picks wharf all of the losses combined, all of them. And if you look at his style, he is someone that looks at valuation but will buy even in spite of an insanely high evaluation. So he has influenced my style greatly.

Brian Feroldi (42:22):
Another one is a Motley Fool member named Tom Engle. He’s an unknown investor to a lot of people, but he has been living off his portfolio for more than 30 years. And his style is to buy great companies at better and better prices, better and better value points over time. So he takes valuation very seriously, but he tries to find companies that he thinks can grow for 10, 20, 30 years. And then he tries to add to that company again and again and again at better and better valuations over time. That style really resonates with me. He’s someone that’s influenced me a lot.

Brian Feroldi (43:01):
And then the final would be a guy named Jeff Fisher, who is also from The Motley Fool. He’s one of their portfolio managers on their professional side. He runs their hedge fund. His style is to exclusively invest in the highest quality businesses that he could find. He is more along the lines of a GARP investor, where he demands everything. You have to have great economics. You have to have a wide moat. You have to have a great management team. You have to have a great TAM. You have to have a history of beating Wall Street’s estimates. You have to be low risk. You have to have a great balance sheet, everything. He demands everything. But when he finds those, he’s willing to buy them and own them for long periods of time. And he has a phenomenal track record.

Brian Feroldi (43:41):
There are literally dozens of other people that I’ve picked up [inaudible 00:43:44] from here and there. But if you forced me to say, I would say those three influenced me the most.

Trey Lockerbie (43:49):
Awesome. And one of the other things I’m also curious about given your checklist approach is what has most recently gotten you excited? What is the company that has scored maybe the highest that you’re doing research on maybe even right now that you’re excited to get up in the morning and grab your coffee and getting to work on?

Brian Feroldi (44:09):
Well, the companies that score the best on my checklist, they’re generally high-quality businesses, but I don’t get extremely excited about them. For example, I’m really bullish on Adobe Systems. It checks nearly every box that I look for in a great investment. So I have a lot of my capital. That’s a major position for me, but that’s not a company that super excites me. That’s more of, “I’m going to buy this thing and I’m pretty sure it’s going to beat the market over long periods of time.”

Brian Feroldi (44:39):
I get the most excited when I find small companies that I think could be 10, or 20, or 30x. And they check a lot of the boxes that I look looking for when they’re still small, but I understand upfront that they are highly risky. So a company that really has my attention right now and has since I discovered it almost two years ago, is a tiny little company that’s worth less than a billion dollars called Semler Scientific. Semler Scientific trades over the counter. So know that upfront, this is a very illiquid stock. So really do your research on it because the price can move around drastically.

Brian Feroldi (45:13):
But Semler is focused on helping physicians to diagnose peripheral artery disease. So that is when there’s a blockage in the arteries of the arms and the legs. This is an incredibly common medical condition and it is significantly on diagnosed. The reason is it’s a pain in the butt to diagnose this disease using traditional methods. What Semler did is they created a little clip that goes on your finger or your toes, and it measures the flow of blood to each of your extremities. And it produces a report on a computer within five minutes that shows you how much blood is flowing to each of your extremities.

Brian Feroldi (45:58):
In the case that blood is not flowing to one of them, your doctor can then take action and you’re prescribed drugs, maybe you’re prescribed surgery. And this can prevent people from having heart attacks, prevent people from having strokes. Cardiovascular disease is the number one killer worldwide so Semler’s technology makes something that is hard to diagnose, easy to diagnose.

Brian Feroldi (46:19):
What fascinates me about this business is their business model. Yes, they make this little hardware clip that goes on your fingers and toes, but they don’t care about that. They just want the doctor to have that. The way this company makes money is by selling the reports that come with it. So that takes a one-time hardware purchase and turns it into a repeat purchase business. And the economics of this small company is just fantastic. Last quarter, this company grew its revenue 125% to $14 million.

Brian Feroldi (46:47):
So again, very, very small still, however, the company is so extraordinarily efficient that it turned that $14 million in revenue into almost $7 million in profit and that’s after-tax profit. So that’s a net profit margin that the company has done of over 40%. And if you look at the technology, there are lots of reasons to believe that they can grow and an above-average rate for a long period of time.

Brian Feroldi (47:13):
Now there’s plenty of risks that are worth noting here. This company has a few major customers that are out there, as I said, it trades over the counter. So its stock is very illiquid. But this is a company that every time I look at the earnings report, I just want to learn more about this business.

Trey Lockerbie (47:28):
You recently released a chart on Twitter that I really loved and it was basically breaking down five different stages of a company. So I’m curious when you talk about Semler, where do you think they fall given that they’re such a small company today, maybe walk us through the five stages where you think maybe Semler sits and how we should think about valuation along the way.

Brian Feroldi (47:49):
So Semler is a bit of an outlier here because it’s right now in the hyper-growth phase. And when a company is in hyper-growth, it is usually not profitable or its profits are very small. So in Semler’s case, it is growing rapidly the top line, and it’s growing rapidly the bottom line. That’s a weird dynamic. So for a company like Semler, I think, the P/E ratio is usable because this company is fully optimized for profits.

Brian Feroldi (48:19):
One mistake that I see investors making over and over again, and I made the same mistake myself for years, is once they learn about the P/E ratio, they think it’s universally applicable to every company all the time. And that is just a big mistake. If you were on the clock 20 years ago and look at some great growth stocks, they had P/E ratios that were 500, 1,000, 2,000.

Brian Feroldi (48:44):
And if the only thing you know is you’ll have to buy it when the P/E ratio is below 20, you’ll automatically pass. I made this mistake myself with a company called salesforce.com. Back in 2006, the company I was working for adopted salesforce.com. And I was like, “This software is incredible.” And if this software went down, our commercial team would literally be useless. It is that important to us. But I looked at the stock and it had a 100 P/E ratio. And I said, well, too expensive, can’t buy it. And the stock is up 20 fold from when I passed on it because the P/E ratio was too high.

Brian Feroldi (49:18):
The reason the P/E ratio was so high is the company was rapidly reinvesting in itself to grow its sales team, to build out its research and development team, to expand internationally. All of those things cost money. Because the company is still in the hyper-growth phase it is not optimized for profits, it’s optimized for growth. When a company is optimized for growth, its profit margins are often very, very small.

Brian Feroldi (49:46):
So let’s pretend that a company brought in $100 in revenue. Maybe it’s only keeping a dollar of that as profit. Whereas if the business is fully optimized for profits, it could probably keep $10, or $15, or even $20 as profit. That means that the earnings of a company are temporarily understated significantly because it’s re-investing so aggressively.

Brian Feroldi (50:09):
Therefore, the price-to-earnings ratio is significantly overstated. And that’s why if you look back at some great growth companies, they often trade at four or five, 1,000 times earnings. The earnings that you’re looking at are artificially low, which makes the P/E ratio artificially high. Once I understood that you realize that a P/E ratio is only useful if a company is mature and fully optimized for profits, then the earnings is a stable number that you can use to reduce the value of a business.

Brian Feroldi (50:43):
So in general, when it comes to looking at high-growth companies, you have to know if the P/E ratio is useful or it’s useless. And you can figure that out by thinking about what stage of growth the company is in.

Trey Lockerbie (50:54):
I recently interviewed researcher and author Jim Collins, and one of my favorite principles of his, and I’ve been thinking about it a lot lately is this idea of the 20-Mile March. So according to Jim, the greatest companies have something he calls a 20-Mile March.

Trey Lockerbie (51:09):
And the easiest way to think about this, imagine two people riding bikes across America, the first person rides 20 miles every single day without fail. So through sunshine, snow, rain, they power through and get their 20 miles in. The second person starts strong with 40 miles on the first day, but then they tire out. So they only ride 10, maybe the second day. Then a storm comes in and they said, “Okay, I’ll sit out for the day, but then I’ll make up for it tomorrow with 50 miles.” And you can probably tell how this ends, but essentially the consistent 20-miler wins the race.

Trey Lockerbie (51:41):
And I think the important piece of this is the governance of the 20-mile marker. Meaning, say the first bicyclist stops at 20 miles, even if he’s feeling great. So even if the sun is shining, I’ve got my 20 miles in, I’m going to stop. That discipline and governance are really important. And some of the principles you’ve laid out today are reminding me of that. Starting with a 0.5% allocation, not letting it go over 3%, et cetera. I’m curious if this resonates with you and maybe if you find any of these other 20-mile marches in your own life, either personally or professionally.

Brian Feroldi (52:20):
But kudos for interviewing Jim Collins. He is one of my favorite writers and business thinkers of all time. I just absolutely love all of the work that he has done. And yeah, this is a principle that I absolutely love and anybody who is in the content creation game, whether they’re making a podcast, they have a blog, they’re on social media, this should really hammer home for them.

Brian Feroldi (52:42):
Because it’s really easy to start a blog, start a YouTube channel, start a podcast, and get really excited about it. And you produce a ton of content in the first month, two months, maybe three months, and then it becomes a grind. And all of a sudden you start running out of ideas and your postings become inconsistent. And that’s especially true if you’re not getting that feedback from people early on, if you’re doing a lot of work, but you’re just not getting an audience, it can be really disheartening.

Brian Feroldi (53:10):
So I personally have a checklist that I make for myself every day where I say, here’s my exercise goal for the day, here’s my posting goal for the day, here’s my work goal for the day, here’s what I’m going to be eating for the day. And I really try and outsource my thinking about what I’m going to do on any given day to a piece of paper. In general, I’m just a huge fan of writing things down, write them down, and make rules for yourself. You can make good rules for yourself when you’re in a calm mood when you’re thinking clearly when you can think about the long-term.

Brian Feroldi (53:48):
If you’re in the day today, and this is especially true if you’re investing, if you have no rules for yourself and you’re feeling tired and a stock you own is down and you’re not in a good mood, it’s easy to make mistakes. I know because I’ve made just about every mistake that you can possibly make. So I’m a huge fan of writing things down for yourself, making rules. And then once you have made the rules for yourself, those rules become the boss of you.

Brian Feroldi (54:15):
So yes, I really resonate with this concept of having consistent goals for yourself and executing them daily. I try and execute health goals, food goals, relationship goals, and investing goals daily. But I do have a habit of overdoing things. I will say, I am probably guilty of going 50 miles, and then 10, and then 30. So I probably should get better about being consistent 20 and stopping. That is a key part of it, is having a stop. But overall, I would say I’m fairly good at being consistent with the things that I do.

Trey Lockerbie (54:47):
I love it. Brian, this has been a true pleasure. I’ve really enjoyed chatting with you today. Before I let you go, I definitely want to make sure you have an opportunity to hand off to our audience where they can learn more about you, follow along with what you’re up to in any work you want to inform them about.

Brian Feroldi (55:01):
I’m most active on Twitter. That is my primary social media outlet. So I’m @BrianFeroldi, B-R-I-A-N F-E-R-O-L-D-I, and I’m also putting a lot of time into my YouTube channel, which is also Brian Feroldi. And on that channel, we take stocks that are recommended from the audience and I put them through my checklist in real-time. So if you’re interested in learning about my checklist and how I find the information, you can subscribe there.

Trey Lockerbie (55:27):
Fantastic. Well, Brian, we should do this a lot more often. I really appreciate you coming on the show. Thank you.

Brian Feroldi (55:32):
I would be happy to try. I had a lot of fun.

Trey Lockerbie (55:35):
All right, everybody. That’s all we had for you today. Before I let you go, if you’re interested in filtering down from a wide universe of stocks to see what might be the best performing in the future, I highly encourage you to also check out theinvestorspodcast.com or simply Google TIP Finance and it should pop right up. Brian and I began our dialogue on Twitter, so I highly encourage you to follow me and we can get in touch that way as well. And with that, be smart, be safe, and we’ll see you again next time.

Outro (56:01):
Thank you for listening to TIP. Make sure to subscribe to millennial investing by The Investor’s Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only, before making any decision consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.