Investment process
Run at your own best pace
In this post I will review my 50 year investment performance. I will take a look at what I have learned and what I think it takes to achieve superior investing returns.
We will look at the compounded return on our retirement savings over the period from January 1, 1973 to December 31, 2022. The numbers below show compounded total return i.e. including all dividends and interest. At most times the return came from stocks but there were a total of ten years during this period when the returns came from bonds or 90 day treasury bills.
There was only one pot, the retirement savings of my wife and me. It is performance of the investments in that pot we are looking at. It’s not like investment products where we only learn the performance of the funds that succeed. The start date is the year our first child was born. We decided we had to get serious about our money and start saving for retirement.
Performance
If you had invested in the S&P 500 and incurred no fees or expenses, over the fifty years you would enjoyed the S&P 500 Index compounded Rate of Return with Full Dividend Reinvestment [total return] of 10.51%.
Over this same period the compound total return on our retirement savings has been 13.00%. This number looks strangely rounded. But, that’s what the calculation produced. So, over the 50 years we have beaten the market.
Beating the market
I don’t think anyone should try to beat the market. I never set out to beat the market. And I’m convinced that trying to do so would skew your decision making. You have to run at your own best pace. If you try to run at someone else’s pace you will underperform and not do your best.
I have always kept track of our yearly investment returns. Until about ten years ago I would occasionally calculate the arithmetic average of our annual total returns for fun. On January 1, 2009 our discount broker started providing account performance numbers. I saw in time that they also displayed multiyear compounded performance and a comparison with total return indexes also compounded. I found on the internet a service to calculate compound returns and started to do so. At that point I saw that we had beaten the market over the years.
Today, my only ambition is to achieve the very best returns I can. If I find we are lagging the S&P 500 for an extended period, I will simple put us in a low cost index fund.
Is it worth it?
Many investors and advisors say it takes a lot of time, trouble and aggravation to invest in individual stocks. They wonder how it can all be worth it. They also say it is virtually impossible. They suggest its far better to just put your savings into an index fund.
To this I say four things. First, I do think index investing is best for the vast majority of investors who want to take advantage of the superior performance of stocks. Second, in the last few decades I have spent a few hours each Saturday morning to manage our concentrated portfolio of stocks. I enjoy it and don’t find the volatility a bother. You get the same volatility with indexing. Third, it is not impossible. In fact it is entirely doable. After all, the S&P 500 is simple an index. There are a lot of ‘has been’ companies in there. Fourth, there are decided advantages to achieving superior investing results even if they are one or two percent above the indexes. Let me offer a simple calculation:
If you start with $100 and compound it at 11% over 50 years you end up with $18,456.67
If you start with $100 and compound it at 13% over 50 years you end up with $40,286.98
It’s amazing that 2% makes such a big difference. In fact our difference is 2.49%. I did this calculation on a pocket calculator so I can’t absolutely guarantee the precise accuracy of the result. But you get the idea. Every extra percent return you can achieve makes a huge difference. This is why we are constantly reminded to keep fees down to a minimum. We have never paid fees, just the nominal trading costs of our discount broker. And we don’t trade very often.
Einstein is supposed to have said: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Do you have what it takes?
You don’t have to be a genius to be a successful investor. In fact, being too clever may be a drawback. Think of Isaac Newton who lost his shirt in the stock market. Think of Long Term Capital Management with its Nobel Prize brainiacs.
What is needed first is a desire to do it. Many people have no interest in managing their own money. That’s fine. I frankly enjoy investing. I enjoy the challenge.
Second, and connected to the first, you have to be willing to work at it. Working at it means spending time to learn about investing and the stock market. Working at it also means doing your homework on the companies you want to invest in. Investing does not take kindly to dilettantes.
Third are what might be called personal qualities. These can be divided into two group: (A), personal traits like self-reliance, patience, discipline, self-control, humility, risk tolerance and resilience; and (B), cognitive skills like the ability to think analytically, think creatively, and whether you have old fashioned good judgement. You can decide for yourself if this is you. On the nature/nurture front, I’m convinced great investors are not just born. They learn from reading and doing and their personal qualities can be nurtured.
Investment process
I’m convinced the main requirement to achieve superior investment results is to have a sound investment process coupled with an understanding of investment psychology.
Robust across a wide range of futures
Your investment process must be robust and able to cope with uncertainty. We live in a world that is radically uncertain. Humans do better than computers in dealing with uncertainty. Humans can often reason their way through problems based on experience and intuition. The starting point in developing a robust investment process is to have a clear idea how the stock market works.
My view is that the stock market is not especially efficient. Over the years I have noted that prices in the stock market are most often higher or lower than fair value. I have suggested it would be better described by an Inefficient Market Hypothesis. It is essentially a complex adaptive system.
Investment decisions must be robust across a wide range of futures. We can’t know what the future will bring. We must be positioned for success no matter how the future unfolds. For example, when looking at the future, one’s investment decisions need to accommodate all of the following: a wide range of inflation rates, a wide range of interest rates; a wide range of economic conditions; a wide range of technological developments; a wide range of outcomes for different sectors of the economy; a wide range of company business models; and a wide range of geopolitical futures. This necessarily means serious attention to balance and diversification.
Robust with respect to company selection
Warren Buffett tells us to invest only in 7 footers, to use his basketball team metaphor. I use analysts’ reports, particularly ones with estimates of fair value. They offer views on the quality of the companies I’m looking at. I don’t leave it there. I like to do my own business analysis of every prospective investment. I particularly like to study a spreadsheet of numbers, seven years if I can get them and five at a pinch. I think of it as doing an inspection of the numbers. I run my eye along a line for each of Revenue, Operating Margin, Diluted Earnings/Share, Operating Cash Flow, Capital Spending, Free Cash Flow, Average Shares Outstanding, Return on Equity, Return on Invested Capital. The numbers go up and down (hopefully not too much down) over the years and give a picture of the profitability of the company. My question is always: ‘is this a superb company?’
In a nutshell here’s what I am looking for. It’s not the first two on the list. It is the third of this list:
Three kinds of profitable companies
- Make lots of money but have no opportunity to put the profits back into the business profitably. May pay a substantial dividend and/or buy back stock, or make silly acquisitions.
- Make lots of money but after outlays to maintain the business they have nothing left at the end of the year to reinvest back into the business. May pay a dividend because they always have.
- Make lots of money and have opportunities to reinvest profitably. May or may not pay a dividend.
It will be clear enough by inspection of the numbers whether the company’s revenue is growing. Next, looking at five years of Operating Cash Flow, Capital Spending and Free Cash Flow will give you a good idea if the company is easily able to handle its capex. If it can and if it has lots of free cash flow to invest in growth you will get a good idea if the company has the money to continue to grow. Years of high Return on Invested Capital will give some indication of the essential profitability of the company, although the number for ROIC may be inflated if the company has a lot of intangible assets not shown on the balance sheet.
Management and Directors
Another really important consideration is alignment of interest (through share ownership) and rock solid integrity of management and directors. I have written about this in other posts, so it just needs to be mentioned here.
Robust with respect to value for price paid.
In the old days I wasn’t as clued in about the need for buying with a margin of safety. I saw sell side analysts’ reports with target prices well above current price and I thought a nice spread between price and target was all I needed. Also, I thought paying ‘full price’ made sense as I was depending on holding the stocks for a long time and with dividends and capital appreciation I would do well. I have come to realize how uncertain estimates of fair value are and that sell side analysts’ target are almost always too high. Because of market volatility investors are regularly offered excellent companies at bargain prices. Now, I will not buy a stock unless I can buy it at a very attractive price.
Value vs growth
The idea of value stocks and growth stocks is a (false) dichotomy created by the investment industry. As Warren Buffett would say, growth and value are joined at the hip. You cannot come up with an estimate of the fair value of a company without considering its growth. What I practice is value investing, in the sense that I look for growing companies that can be bought at a price that is less than the fair value of the stock.
It is often said that to achieve superior results in investing you need to have an edge. In a sense all investors have an edge. If you put $100 into an S&P 500 index fund you are essentially certain to come away with a positive return over the long haul. To achieve superior returns you certainly need to have a sound investment process. You also need to have a special edge. Some think the special edge comes about through an informational advantage. Nowadays, timely information is broadly disseminated. Others say the special edge can only come about through exceptional insight. I must say I think it hard for any investor, even high profile money managers on Wall Street, to have insights beyond their competitors.
I think the best place for individual investors to find an edge is through investment psychology. I would call it a behavioral edge. I’ve written a lot about this because I believe in it. See Investment psychology explainer for Mr. Market – introduction
Mr. Market is alive and well. He is quite obliging in offering up bargain prices of superb companies from time to time.
Good things don’t last forever
One is investing for the long haul. Our favorite holding period is forever. But, even the best companies are subject to a natural cycle of company formation, growth and decline. This is why you have to monitor them closely to see whether the company is starting to lose its way. As well, you must never fall in love with a company. Or as behavioral psychologist would say, watch out for the endowment effect warping your thinking.
Conclusion
This short post gives a broad brush picture of what I have learned investing over the years. Of course there is a lot more to it. The devil is in the detail. The tags index on the right side of the home page of this blog provides links to over 150 short posts on all the different subjects listed. I invite readers to look through the tags index and check out subjects that may be of interest.
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right-hand side of this page to find references in both blog posts and also in the Motherlode.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
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