Sunday, April 12, 2020
How to Invest
It is important to understand the fundamentals of investing if one is going to commit hard-earned money to the investment process. Like any worthwhile endeavor, it is helpful to first ask questions. One of the most important questions to ask is "Why?" Why are you investing? What are your goals? Are you willing to learn the investment process?
Before reading any further, get out a piece of paper and write down answers to these questions. Consider this a contract with yourself listing your reasons for investing, your goals, and your commitment to the investment process. This "Investment Contract" is a living, breathing document that can be amended and improved over time. Carry it with you in your wallet or purse. With your Investment Contract in hand, let's begin.
Typically an investor buys something (real estate, stocks, gold) with the anticipation of it going up in value over time. Some of the most successful investors in the world, however, consider investments in terms of cash flow. This means they classify investments as assets; an asset being in the strictest definition of the word something that pays YOU to own IT. I will focus this post on the asset class of stocks because they are my speciality. Although there are multiple other asset classes in this world, stocks are what I live and breath, so I feel comfortable discussing them in depth and at length as an asset class.
What is a stock? I consider a stock to be a small, almost infinitesimal or atomic-level, ownership of a company. A stock is a piece of corporate DNA. What this means is that those shares you own represent not only fractional corporate cash flow, but also its management, brand, locations, industry, and employees. And they ALL matter.
As we're experiencing right now with the coronavirus pandemic, owning a single stock in a portfolio can be very dangerous (airlines, hotels, casinos, etc.) or lucrative (video conferencing, supply chain, logistics, etc.) Most investors, and mathematicians, support the belief that owning a basket of stocks helps to reduce the risk associated with owning a single stock. Traditionally this has been pitched as owning an index or mutual fund or fund of funds with hundreds, if not thousands, of positions. This approach championed by the index fund companies seeks to "own the haystack and you'll also own the needle." Basically, own everything and something will work.
Historically, passive investing has proven to work. Passive investing works primarily because over time the stock market has risen in lockstep with inflation. Also, if you buy everything something usually does work. That would qualify as the growth component of passive investing. Indexes drop the losers and keep the winners in a Darwinian rebalancing. It has several advantages: you can buy stocks in bulk and on the cheap. For many people this is an easy solution. For other people they prefer to actively choose what companies they own. I am of the latter persuasion.
Active management builds custom portfolios. I prefer this approach because I want to know the companies I own, I don't want to own the entire haystack. I prefer to concentrate my firepower (cash) into a handful of viable ideas. Building your own portfolio offers several advantages. Transparency: You know exactly what holdings are in your portfolio. Liquidity: You can typically sell without a minimum holding period. Cost: Most firms have eliminated trading costs or they're negligible. With that said, what do I look for when building a portfolio?
My investment philosophy is biased towards profitable companies, ie I typically only buy companies (stock) that are profitable. It is difficult for a company to pay a dividend or buy back their own stock if they aren't profitable; both of those factors are key tenants for me. There are very few exceptions to this rule. In the quest to find explosive growth, however, this rule is often violated.
A key question investors should ask themselves is: "Am I buying an asset (cash flow positive) or am I paying to help raise money?" Many IPOs fall into the second category. With few exceptions, a company without a plan to profitability doesn't survive. That's not to say founders or insiders in these companies can't become fabulously rich, they can. It's just that they sold their shares to the public to extract their wealth. Know what type of company you're buying.
There are five primary traits I look for when purchasing a company: Do I trust the brand? Does it pay a dividend? What type of sales profile does it have? What does the chart look like? Finally, what type of management is in place? In an ideal situation all five of these factors align; a well-trusted brand that pays a dividend with a high margin/high volume sales cycle having an increasingly higher left to right chart with strong management in place is a dream scenario. A successful combination of these variables lead to the formation of a shopping list. Although many companies may make the cut, the timing might not be right....and as they say, timing is everything.
There are many adages as when to buy a stock. We're often told "it's a matter of time in the market, rather than timing the market," or "the stock market is perfectly efficient," or "long-term investors don't time the market." To some extent all of these sayings are true, but as an investor that has seen multiple Bull Markets and multiple Bear Markets, I can say with absolute certainty that long-term gains (ie time in the market) can be wiped out in weeks, if not days. The stock market is definitely not perfectly efficient; otherwise there would be no volatility, there would simply be a perfectly smooth line. And finally, anyone who has bought before a crash will tell you, holding through a Bear Market is psychologically almost impossible. Couple all these factors with the truth that as you live you will need money for cash flow, very few, if any, people can start investing in their teens and hold until their 60s or 70s. I say again, very few people can simply buy and hold indefinitely. The vast majority of investors, therefore, need some element of timing in their portfolios.
Realistically you have several decades to actively build a base of investments; once again the spectrum is wide in terms of choices. Real estate, stocks, commodities, etc. should ALL be part of your master portfolio. From the stock market perspective in which I operate, however, I can tell you that concentrated portfolios can be wiped out in weeks, sometimes days, and we encounter catastrophic events like these "one-in-a-million" scenarios every 8-12 years. This is why it is essential to build gradually, have multiple irons in the fire, and be prepared. One catastrophic loss should NOT derail your entire future. The Rothschild's proverb was "buy when there is blood in the streets." That is a good one to keep in mind. Warren Buffet famously remarked it is prudent to be fearful when others are greedy, and greedy when others are fearful.
Buying at a dip's nadir is almost impossible because it is a finite moment in time, but buying in a lull is quite possible. I refer to these buyers as "mountain men." Mountain men come down from the mountains during times of crisis, pick up assets on the cheap, and then disappear for a decade until the next crisis. Cheap assets offer a buffer of safety, ie the premium has evaporated due to fear. Many businesses can be had for significant discounts at the right time, usually chaos. This happens often enough as to make the strategy viable. Historically the only assets worth having are gold and cash in the height of a correction. Everything else sells off hard. This is why having a "shopping list" on hand is always a good idea; know what you'd like to buy and at what price.
This leads to one of the more controversial theories I have regarding purchasing stocks; simply put, you shouldn't buy out of habit, but rather by feeling the price is right. Only you know what that is, but "correct" pricing is typically associated with a feeling, and that feeling is nausea/fear...if you feel nauseous buying because there is so much fear in the market most premiums have evaporated. If that isn't possible, consider the default approach of dollar cost averaging a basket of stocks. Although not ideal, it has worked over the long-term for many investors. The danger to long-term investors, however, is always the market cycle.
For those who haven't experienced a Bear Market, where every day is worse than the previous, the concept of a market cycle might be meaningless. Retiring into a Bear Market, however, is brutal. Forced selling into a Bear Market is brutal. Looking for work in a Bear Market is brutal. Bear Markets are good primarily for Mountain Men, for most other investors it is a horrible experience. Many sell and and never return...once mauled, twice shy. What is an investor to do? A lot depends on your risk tolerance, time horizon, and investment goals.
If you have a high risk tolerance, where suffering a loss to your net worth of 50%+ within a month doesn't faze you, I don't believe you. For most investors, the percentage loss to a portfolio to cause panic is actually relatively small; somewhere around 5-10% elicits immediate concern. For those who haven't experienced an economic collapse, a 20% loss seems apocalyptic. Keep in mind though, fewer than 50% of all small businesses survive 5 years. So from a stock market investor standpoint, a 5%, 10%, even 20% drop isn't irrecoverable. The problem with selling is that typically once sold, the cash flow ends. This leads me to my final point. Time.
Time is the most valuable commodity. If something looks like a bear, walks like a bear, then it probably is a Bear Market. In answering the market cycle/timing postulation, an investor needs to be able to sleep at night. Being dead is bad for business. Time fixes most long-term problems in the stock market and your portfolio, but there are interludes, however, that are so volatile that many investors are shaken out permanently. Permanence is a long time. A way to avoid this is to buy a basket of quality, diverse, cash-flowing businesses over time. Have ample cash on hand (preferably with a healthy slug of gold too), and avoid leverage. These strategies can increase your resilience to selling, and increase your propensity to BUY in times of distress. When to sell? Holding periods should be thought of in decades, if not generations. Take a dynastic view of your gold dragon egg.