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To Build a Solid Foundation, Use Bricks

Here's a sacred truth that applies not just to investing but to life at large: who we are and how we perceive the world has a lot to do with our roots. Yes, lineage matters. But it's also the coincidences and chance encounters in our backgrounds that make a big difference too. Both apply in my case.

I grew up in the Bay Area, specifically, in El Cerrito, California, a block off Navellier Street. Having a street named after our family wasn't because we were the town's wealthiest or most prestigious citizens or because our ancestors committed extraordinary acts of civic achievement.

It had to do with longevity. Many of the streets in El Cerrito are named after early homesteaders who came to California following the gold rush. Initially, the town was called Rust after Wilhelm F. Rust, a German immigrant who arrived there in 1883. The population grew as refugees from the San Francisco earthquake and fire settled there, and in 1917 my town was renamed El Cerrito.

It was my great grandfather and namesake, Louis, who immigrated to the area in the 1880s, and it was his time there as a teacher that got him a lot of land, as well as his street. Back then land was granted for free to those who would settle it, and initially, he had quite a few acres, but a lot of it was lost during the Depression. He came from Oloron-Sainte-Marie in the French Basque country. I think this is a not insignificant part of my makeup. The Basque are known to be fiercely independent, larger than most Europeans, and lovers of fine cuisine. Check, check, and check.

My grandfather did live on Navellier Street, and we lived behind him on Scott Street. Our houses backed up to one another, and my father and uncle built on land where my great grandfather had a chicken coop and a garden. Unfortunately, a bobcat got into my great grandfather's chicken coop, so that was tragic. Interestingly, the home my dad built was on the old family garden and had well water, which came in handy during the California drought in the 1980s.

My father, Ernest, was a bricklayer, which meant that I spent a good deal of time in my youth carrying hod, which is the art and drudgery of carrying bricks and mortar to the masons or bricklayers on a job site. I was lucky to be able to do it at all. My father, at the tender age of 18, was a ball turret gunner on a B-26 bomber in the European theater during World War II, a post that carried an enormously high mortality rate. He was lucky, since as a ball turret gunner, he rotated with different crews and unfortunately most of them died. To him perhaps, the rhythmic labor of laying bricks in the absence of mortal danger was enough to keep him happily occupied for a lifetime.

I should add that my father was also an excellent golfer and his putting skills were unmatched due somewhat to his geometry skills. For my part, I didn't hate carrying hod, but I didn't love it either. However, whenever I could, I tried to switch to being a caddy at a golf course, since I found that to be easier and more rewarding.

But there was one aspect to laying bricks and carrying hod that left an indelible impression on me. If you wanted it to, bricklaying could be a highly numerical exercise. I had to exactly match my father's pace to deliver the bricks not too soon or not too late to keep him moving at a steady pace. I had to adjust my pace when he got weary as the day wore on. His rate of production would tell me how long a day it was going to be. There were areas to be calculated, relationships between height and stability to be considered, incidences of defective bricks to be factored in, and calculations to determine how defect rates would impact production. Yes, algebra, geometry, statistics, and even, in rudimentary form, differential equations were all embedded in bricklaying, and ultimately these subjects played a large role in my career.

Going to college was all but certain. My father was still closely allied with his immigrant roots, so he was highly motivated to propel his children further than he got, and I was his only son.

Growing up in the Bay Area, we had no concept of going to a non-California school. I got into Cal State Berkeley but chose Cal State Hayward because I could complete a degree school faster there. In addition, I wouldn't have to take "bonehead" English, which I would've had to take at Berkeley. This was important to me. While I was among the top 1% in math based on the SAT exam, I was also in the bottom 11% in English. So, I decided to go to Hayward where I finished my B.S. degree in three years and finished an MBA a year later in 1979. Studying advanced math there was challenging and interesting, but I didn't see it as useful in solving everyday problems. Statistics, on the other hand, would tell you about outcomes. Though I didn't know it at the time, statistics and the ability to forecast a variety of outcomes would be one of the cornerstones of my career.

The course of one's life often depends on a few key decisions or chance encounters, and mine is no different. At Cal State, one of my professors was doing work for Wells Fargo. He was using Wells Fargo's mainframe computer to build the index products that were emerging at the time, and he asked me if I could help him.

At the time, I had a slide rule as well as a programmable calculator, just like most of my peers at Cal State. Getting access to a mainframe computer was a revelation. It was like giving a gold prospector a diesel-powered excavator to replace his picks and shovels.

My task was to build an index that tracked the Standard and Poor's 500 (S&P 500) with fewer than 500 stocks. After finding a subset of 320 stocks that I expected to precisely track the S&P 500, I failed miserably at that because my 320 stocks actually beat the market! Why? This problem was as exhilarating as it was vexing.

Digging deeper, I found a number of anomalies and inefficiencies. But the most interesting thing I discovered were stocks whose returns were uncorrelated to the market. At the time, this was a nascent concept that was pioneered by legendary economics professor William F. Sharpe. All of my other textbooks at the time said that a variable known as Beta, which measures the correlation between a stock and the market, is the primary determinant of performance. However, Professor Sharpe pointed out an uncorrelated relationship between a stock and the market was defined as Alpha.

I set out to prove that Alpha existed and could be used to price and value stocks. Even though I was still in college at the time, proving that Alpha did indeed exist, and putting it to work to discover great stocks, would become my North Star. The importance of Alpha is tackled in more detail in Chapter 10, which explains how it can be combined with other statistical calculations to identify stocks that are capable of delivering outsized returns.

My days at Cal State ended, and I continued to work on the statistical analysis of stocks but at that point had to earn a living. I took a job with the Federal Home Loan Bank Board as an industry development analyst. Savings and loan associations at the time required approval for every branch they opened, and my job was to ensure that the branches were in sustainable locations.

Things got more interesting when the savings and loan crisis hit in 1986. I was part of a team that oversaw the mergers and acquisitions of the banks as they scrambled to save themselves. It was an experience that stuck with me, but not in a good way. I saw too much sausage being made via bank accounting, and to this day you will see very few banks in our portfolios, mainly because many banks are very good at masking their delinquent loans.

I started with the Federal Home Loan Bank Board in 1979 and on the side began publishing my first newsletter. I ran an ad in Barron's in 1982, which tipped off the Federal Home Loan Bank Board to my side hustle, and we parted ways. While up until then publishing was an avocation, now I had to make it work as a business. In those early days, the operation looked exactly like any bootstrapping publishing company. The publisher, editor, and senior writer was the same person stuffing the envelopes and dropping the newsletters into the mail.

That first letter was called OTC Insight. Eventually, I added a partner, but after we parted ways, my newsletter was renamed MPT Review. MPT stood for Modern Portfolio Theory, which was a nod to my academic roots.

MPT Review evolved into Emerging Growth in 1983 and in 2019 reached its current incarnation with Breakthrough Stocks as the flagship publication alongside Market 360, Accelerated Profits, Growth Investor, and Platinum Growth, and with the total circulation in excess of 560,000 readers.

Although my publications have evolved, my approach has never wavered. We blend a quantitative analysis measuring risk and reward indicators and combine it with a fundamental analysis focusing on exceptional profit margins, excellent earnings growth, and reasonable price/earnings ratios.

Quantitative and fundamental analysis are typically separate disciplines. Combining them is not revolutionary, but it is uncommon. Further, with respect to quantitative analysis, when measuring reward (alpha) and risk (standard deviation), the devil is in the details. After nearly 50?years of measuring stocks quantitatively, we have honed our analyses, and this evolution has led to improved performance over time. As...