Stock market investing – IFB14: Why Investing Metrics are More of a Guideline than a Blueprint



Stock market investing

investing metrics


 

Welcome to the Investing for Beginners podcast. In today’s session we talk to Steve from England! Our little podcast is international, and we discuss some great topics. Our main focus is on investing metrics and how they are a guideline and not a blueprint for your investing success.

  • How much to allocate to different investments and what size investments to make
  • Setting up watchlists for different types of investments
  • The best metrics to use to find the best stock ideas
  • How to balance dollar cost averaging and trading fees
  • What are the best stock screeners out there and should you invest in those services
  • Are small caps a good investment or are they too risky

Andrew, was wondering when you split from your regular investing to adding the Dividend Aristocrats? Also how much do you invest in them, and when do you do it, and what size decisions do you make?

Andrew: I love that question, the basis of my approach is trying to let’s take somebody the average basically, a hard working citizen in any country. This show is now a global thing and let’s not exclude lower income, people who aren’t making seven figures and have umbrellas of wealth, these parachutes they can fly off if they make a mistake as a CEO. Let’s look at the average person, people who don’t have much but can scrimp and save a little bit, do that each month. And let’s see if those people can make a fortune, the working class of the world. Obviously, I am talking about more developed countries, aside from that, how that relates to my whole investing approach is the ultimate goal is for the investments to have compounding interest in the most efficient compounding machine we can get.

So we’ve talked about in previous episodes about dividend reinvestment, the drip and how that can roll down this hill of compounding and multiply the type of returns that we can see. The problem is when you’re investing smaller amounts of capital, you can’t always assume that you’re going to find a dividend aristocrat every single pick. If you have a portfolio that’s twenty positions, I like to keep it around 15 to 20. To think that I can pick a stock every single month and expect it to raise it’s dividend every year.

So every year they raise their dividend, and you know the way that Dave and I approach investing is that we are trying to buy at a discount to intrinsic value. That already limits our pool of available investments because not every stock going to be a great buy at its current price. There are plenty of stocks that are great cash machines, they have fantastic businesses, they are growing their dividend like crazy, and they have a high dividend yield, but if the stock is priced too highly and too expensive then suddenly that’s not the most optimal place to put our capital.

Knowing that in the end, it doesn’t matter whether you’re talking about low amounts of capital or high amounts of capital. That 15 to 20 reality of having that kind of a diversified portfolio is going to answer this kind of question already, especially when you have lower amounts of capital. I like to; you mention in the eLetter how I split it up between the Dividend fortress and the regular positions.

I like to accumulate several positions worth of capital and then plow that into a dividend, it doesn’t have to be a dividend aristocrat, but it should have potential to be a dividend aristocrat. If you look at any of the fund managers, they will do this too. If you are just starting out with a portfolio, and you don’t have any diversification, and you are just going to dollar cost average like we recommend that you do. It is going to take you some time to build up positions and eventually you are going to want to get to a point where you have 5% of each position in your portfolio. That’s a nice even, equal, just straight diversification. Similar to the way that you would get if you indexed that’s equally weighted, not market cap weighted but equally weighted for every position where every position is worth the same percentage.

But if you look at the fund managers and the ones that have been successful like Seth Klarman, Warren Buffet, name whoever that has these filings that you can find online, and a lot of them have heavy weights on certain positions. They take more calculated risks; they still have very diversified portfolios. But sometimes that’s the name of the game, and they have certain things that we don’t know about, we are not in their shoes and don’t see what kind of things they need to take care of.

You’ll notice that some of Buffett’s biggest investments and this kind of goes to the 80/20 rule, where 80% of your results can come from 20% of your things and that can apply to stocks as well. But if you look at some of his most famous investments, you have GEICO, Gillette, Kraft Heinz, and he has these positions that have played out. GEICO is a perfect example where he put in a ton, a big chunk of his portfolio, reasonable not talking about 50% or anything, it made up 10 to 20% of his portfolio, and that’s not crazy.

When you have more heavily weighted positions then if you can hit that sweet spot where they also have dividends and they are growing their dividends and now your just getting flows of dividends and crazy high yields on cost then that’s the end goal of that.

The reason the why I talk about really trying to get a couple of positions worth of that is because even let’s say you find a company like that, but only 5% of your portfolio is in such a situation. Yeah, you’ll get some nice returns off of that, but it doesn’t unlock as many dividends and as much reinvestment as you can get when you combine positions and have larger position sizes, calculated risks. Things where you see an opportunity lineup that is a greater opportunity than there normally is. It’s in those times that I like to not only use the VTI to find a good stock but also try to find a stock that has great potential to become a dividend aristocrat.

I think that naturally the next question would be well how do we know that a stock is going to be a dividend aristocrat? There’s obviously no way to know, but a great way and a great indicator potentially are the longer some consecutive years that raised their dividend up to this point the better chance they’ll continue that moving forward.

Now, of course, you want to have the stipulation that they need to be having a prudent payout ratio, they can’t be paying to much of their earnings out they need to have an outlook like there future is going continue to have growing earnings to support a growing dividend. All those things come to mind but the consecutive years of dividend growth are real if you combine that with the VTI if you combine that with seeing long-term growth with a couple of other ratios, that is a nice synergy of finding stocks that can become dividend aristocrats.

Like I said, it’s not an opportunity that is going to pop up every single month that you want to see it. I’ve been lucky in that with the eLetter for those who have been paying subscribers, and they have been following along. They’ve seen months where I’ve had one where I rebalanced. We had talked about this before the portfolio got close to oversaturation. It got to a point where if we added another position it would be over-diversified and returns would get closer to what the market averages. We ended up selling a lot of those positions and now if you sell three or four positions in one month, now you have the big lump sum that you can pile into what you hope will be a dividend aristocrat. And let those run long-term. For a dividend fortress I don’t put a trailing stop because I’m so confident in those particular stocks and they have that synergy of low price, high dividend or growing dividend and nice long-term track record, then that’ where I’ll push that money into there and make it grow.

It doesn’t happen all the time, and I’ve been fortunate where I’ve had stocks I’ve been looking at, and they stayed lower, or I had a position that I already had, and then it didn’t move, so I was able to add once I had that additional capital. It’s not always going to be the case, but when you have those situations, you want to pounce on them because the market can turn quick and some of the dividend fortresses I have I can’t add to anymore because they are already up 20 to 25%.

I had an email the other day talking about how the different return rates of those positions. And if I had some excess capital now, and I had a trailing stop that was triggered. And I was selling two or three or more stocks and those dividend fortresses already rise in the price that makes them not a great deal anymore. Then it puts me in a tough spot, and I might have to make more normal stock picks with trailing stops that may or not have good dividend history because the opportunity’s not there. That’s the mindset behind, and that’s the differentiation behind a dividend aristocrat strategy, having a value investing strategy, and kind of making those play in the most optimal way that I can forcibly make it happen.

Do you effectively keep an eye out for the dividend aristocrats or dividend kings? Do you have a watch list that you follow to catch them when they are available or do you wait for them to fall into your criteria and then act?

Andrew: That is an excellent follow-up. I do have a special screen for dividend aristocrats. The way finviz works is that you can put in a CSV, which is a comma separated all these tickers separated by commas, and you can copy paste them in. There was some website where I was able to see all the dividend aristocrats tickers copy paste it, so I have that saved as a screen. I don’t check it every single month, because Like I said I don’t have enough capital.

If I am only doing a $150 a month I’m not going to have enough capital to jump on an opportunity, If it is there really, but I have a watch list. Sometimes I’ll use that watchlist just to make a normal stock pick, but I will keep it on my dividend watch list so that way if I do get an influx of capital. I look back at the watchlist, and if the stock that I bought still has cheap and hasn’t risen in price, then I can go ahead and add that.

Other than that I don’t worry about missing out on dividend aristocrat opportunities because if one’s there and screaming out at me and it’s got that synergy of all three things that I am looking for, and I don’t have the capital. That’s ok because I will just buy a little bit and if the situation arises, I will buy more. When there I say there are limited opportunities that are true for maybe potential dividend aristocrats, I don’t believe that all to be true when it comes to the whole market and just stocks in general.

I’ve had no issues finding an opportunity in the market, and you know that people have been saying since I started which was in 2014 as far as the eLetter started and back in 2013 as far as buying stocks. I just remember people always saying that the market’s at the top, the market is going is to crash, the bull market has been going so long we are overdue for a correction. I’ve heard all these years, and they could be right about it tomorrow, but in the end, there’s still going to be an opportunity. There’s always going to be stocks or a group of stocks that are not priced fairly compared to the rest of its competition at current prices, so there will always be opportunities.

Are there any metrics that you follow or use to find the right stocks to invest in? When are you looking for a margin of safety, do the metrics tell you when you are finding the right stock?

Andrew: I like that question because now you are getting into the intricacies of value investing and it’s showing that you have this deeper understanding of the concepts that are at play. I’d like Dave to chime in after I’m done because he might have a different approach than I do.

I know for a fact that I have a different approach compared to a big majority of the value investors out there. A lot of them like to calculate a specific intrinsic value for any given stock, and I think it’s a great way to go because intuitively it makes sense. The downfall is obviously is that you have to put a focus on something, so whether that’s a more earnings tilt or if it’s more of a balance sheet tilt, there is going to have to be something that is more heavily focused on. In that nature, it gives you a nice concrete, simple.

And I can compare three stocks now and see that one’s .40 for a $1 and ones 0.55 fro a $1 and ones .70 for a $1 and the most expensive two I’ll put on the watch list and the cheapest one I’ll just buy outright. Makes it real simple, makes it real easy. The problem I see with that, to me a margin of safety is not so much maximizing for a discount as it is lowering downside risk and focusing on the safety part. Now that I talk about it if you look at the term margin of safety the value investors like to focus on the margin, that’s the discount, and I like to focus on the safety part.

What I’m looking for is not a particular number whether that be a price to earnings, price to book, price to cash, any of those things. I want the complete picture; I look at it as the difference between cameras. I’ve written about this in a blog post before.

The metaphor I like to use is the difference between having one security camera at your front door that’s ultra precise. It’s 4k quality, it’s saving every millisecond, versus having a bunch of video cameras from the early 2000’s but they surround your house, they are inside your house, they outside your house.

That’s what I kind of look to do with valuation. I look more as let’s make sure everything looks reasonable instead of letting’s focus down on getting a discount. In a sense, yes you will see differences, a lot of the VTI of the four of the seven metrics are going to be price-based. If a stock drops $5, yes, it’s going to make the VTI more attractive, it’s going to be a better chance it’s going to be a strong buy. But the way I’ve crafted the VTI, and the way the formulas designed.

You can get into the mathematical, but I designed it, so you don’t need to be that analytical, and they can still quickly see the differences you just input some numbers, and you can see as it automatically calculates for you. But the way that I designed it was so that, as an example for the PE, the difference between a 25 and a 27 isn’t going to be that great. Same as the difference between a 10 and a 12, but the difference between a 5, which is much lower than a 25 or much lower than between a 45 and as you get increasingly higher away. That is a bad example, sorry.

For the price, to book, I do an exponential thing. The further you get away from the desired price to book value the more it’s going to tilt the VTI in a favorable way. Because you bet, I would love to get a stock that’s trading at a 0.5 PB. I think that’s many scales more valuable than a Price to book of 1. But you know the difference between a 1 and a 0.9, is not as great as going from a 0.8 to a 0.6 if that makes sense. You’re getting increased value with the cheaper it’s getting on that side, and then the same token going up to 3,4,5 Price to book that’s going to throw off all these kind of flags because it’s extremely expensive and not any investor wants to be.

What’s difficult about it I guess, in a way, is that there is no specific number and it all depends on the whole picture. The earnings, the book, the book value, the sales, the cash flow. Even if the stock drops to like $5, there’s not going to be a linear drop in how much more it’s attractive because it depends on how the whole picture is grouped together. I guess confusing if you don’t understand the nitty gritty of the VTI, but I guess in the simplest of terms because I’ve modified the scaling of each ratio, and some of them are exponential, some of them are linear. It goes to what’s more valuable what’s going to give a heavier weighting, and what kind of ratios are just there as stop points, red flags, triggers and which ones are maximizing and trying to get that margin side of the margin of safety, trying to maximize that.

Dave: I guess my thoughts were when I look at the value investing, and the way that I look at it is I’m right there with the intrinsic value that’s my big thing is trying to find what I think the value of the company is versus what the price is on the market. To me, the price is not necessarily the end be all it’s more about what I think it is worth. I like to liken it to buying a house or a car. When you go to buy a house or a car, you think you have you know what it is worth. And so if that person is selling it for more than that then you either have a choice of walking away from that or trying to work with them to see if they can lower what they think it’s worth to where you think its worth.

When I look at a stock or a company that I am looking at interested in buying. I’ve mentioned this before the ebook Andrew wrote kind of my entry into really opening up the metrics that are out there. Andrew and I had a great discussion about this a couple of podcasts ago, and that opened my eyes how everything kind of fits together. I took those, and I’ve said this before, I use those metrics every Monday when I get to work, and I log in, and I screen for stocks every Monday, just looking for things.

And I use those metrics as kind of a guideline; those give me a starting point if you will. This company might be interesting. The stock market goes in and out of flavors of the month, and things that are going to be beaten up and not beaten up and so on. When I find something that I feel is attractive or interesting then what I’ll do is use some of the other things that I use to find the intrinsic value. I will use the Ben Graham formula, DCF, Dividend discount model and I will just look at all those and compare them.

I came across when I have been writing and studying about this stuff recently. I came across a quote that Warren Buffett used, that I thought was poignant. What he said was “It’s better to be approximately right than precisely wrong.” and I thought that was right on the money. Because when I read through a lot of his shareholder letters, which by the way if you have not done that, it is must read information if your even remotely interested in value investing, or even just investing. For that matter entertaining, the guy’s a great writer and some of the things that he talks about; he never gives a precise way that he figures out intrinsic value in any of his letters. If you look on the internet, and I’ve scoured the internet looking for people that are smarter than me to figure out if there was a way to do this. And there isn’t; he doesn’t disclose his specific formula that he and Charlie Munger use.

But he does talk a lot about ranges of values, and we talked a moment ago about buying a $1 for $0.40. He will look at a company, and he will say that I think it is worth $100 million but if it’s at a $120 or if it’s at $80 million. I still might be willing to buy because it’s the price that I think its worth to me, even thought it might be selling at $150 million or $200 million. It’s still below the market value, but he thinks it’s worth a certain range. So he has a range of things that he looks at, and I think that is something that I am going to try to integrate into my investing.

value investing

The margin of Safety, I am right in there with Andrew, I’m more worried about the safety part of it than the margin part of it. For me, the safety part of it is because again I am not the smartest guy in the room and I know that and I am not arrogant enough to think that I am. And so if I make an error in my intrinsic value calculations I want to have, I have to have that safety in there so that my hard earned capital, just like your hard earned capital and Andrew’s is not being blown on making poor decisions. The thing about value investing, and I think you have kindly alluded to this and I think you get where this is coming from, it is about patience, it’s not about eager, anxious, jittery, and thinking I have to buy something now. It’s about finding the thing that’s going to fit what you’re trying to do.

One of the things that I do, instead of buying something every month like Andrew is doing. The way that I do it is that I save that money for three months and then I buy something. What I did have I started a six-month cycle, every three months I will buy something, but I have an extra lump of cash available so if there is an opportunity.

I will give you an example, Gamestop (GME) which is a company that I wrote about and I invested in, and I think its a great company. They got beaten up in the stock market recently because the earnings report came out it was bad, but the underlying fundamentals of why I bought the company in the first place had not changed. But the stock market decided it was a bad company, and everybody ran screaming for the door because they had one bad earnings report, or maybe two bad earnings reports, not negative, not losing money, everything is still going well with the company they are just changing what they are doing. All that being said, all of sudden the price of the stock went below what I had originally purchased at. With having this lump reserve of cash, I was able to buy more of it to add to my position. And that helps my value of the company and its going to help me make more money in the long because A, I’ve got more dividends that are going to reinvest in the company, and B: I’ve got more shares at a lower price which gives me more value over the long run.

All that being said, that’s kind of how I work with the value investing part of it. Dividends are a big part of what I do as well. There are just a lot of different factors that go into it, and if you narrow it down, I guess.

The best way to look at it is I am looking for something that is selling at a discount, and I’m patient, and I’m going to wait for something that is going to be in my wheelhouse and then I am going to pile into it when I can. Monish Pabrai who is one of my big favorites he talks about a lot about betting and gambling and his famous phrase from his books is “heads I win, tails I don’t lose much.” I think that is the perfect analogy for value investing for me.

How do you deal with the fee aspect of dollar cost averaging? How do you reconcile the fees you are paying every month and do they eventually not matter as much?

Andrew: Yeah, your right it can balance out in the long term. Obviously, that depends on the stocks you buy. Also, depends on how much money you’re putting in. For our intents and purposes here in the States Dave and I use both use TradeKing, and we both recommend TradeKing, they have $4.95 trade commission. If you’re looking at investing $500 in one, go that’s about 1% your losing in the commission which obviously not ideal, but it’s not terrible.

The higher you can put away the less of an impact that makes towards your overall return. And again like $1000 stock buy would be about 0.5%, the eLetter is seen the hit big time, you’re talking about almost 3% knock straight off the bat on every trade, and then you get it again on the sell. It’s just hoping for the long-term and understanding that you could have a stock gains 15% if you lost 6% from commissions then that’s too bad, but most of the time you’re going to want to be buying and holding. I mentioned the dividend fortresses earlier; those are all no trailing-stops, hold for the long-term, the market crashes were still holding. It is going to be those type of buy and hold positions where you hit with the one-time upfront fee, and that’s it, and you won’t get it again until you sell.

It’s those positions and making sure a larger portion of your portfolio is in those forever type trades. As long as you do that, then the commissions are not going to kill you that bad. Dave and I like to talk about how the mutual fund managers charge outrageous commissions and their dining on all our hard work. But understand that those commissions are every single year, there giving you these sort of commissions. And a commission with TradeKing is just a one-time thing and then one time when you sell. If you have a long-term approach, you can do some trading in and out. If you have trailing stops, I think that’s great; I do it for the majority of my portfolio right now. And even with a 25% trailing stop I rarely have to make a trade, and probably won’t see that until the market does hit some bear market. You’ll have to execute a lot more trades in the short amount of time.

But over the long term, you’re hopefully holding for a year or two years and your either seeing appreciation or you’re collecting dividends, and it should balance out in the end. More is better when it comes to your capital but that’s the silver lining when it comes to big commissions is that there are ways that you can formulate your approach to work around it.

Dave: And I think to echo off of that. The biggest thing is to find what your comfortable with and to doing the math on your own and find what’s going to work for you. One of the reasons why I do, and I understand why Andrew’s doing the monthly portion of it. The way I do it, one of the big reasons why I started doing it that way was the very thing that you are talking about. I noticed right away if I spent $80 in a month or bought $80 worth of a stock of one company that is costing me $4.95, then I had to wait a year and a half before I would recoup that and I thought that is not going to be ideal.

I decided I would try every three months because for me if I’m putting in $450 every three months that knocks my commission down to about 1.1%, which I can live with. Is it perfect, no, but I can live with that because I know that when I buy those companies, I know that I am going to be holding them for a long time. And they are going to pay me back ten-fold, just in the dividends alone I am going to make that back in a year’s time. That to me makes it worth it for me.

What are your thoughts on stock screeners? Would you pay for the services of a stock screener and are they going to be more accurate?

Andrew: I did some Googling just to see what you were talking about in regards to the London Stock Exchange and a lot of the screeners I saw on there I didn’t like at all. They weren’t specific enough. I did find one that uk.investing.com has a stock screener, and it looks like it is free. They look like they have the ratios that I would want to see.

So I see the price to book, tangible book, price to sales, which looks great. If you end of spending some time on those and seeing that it gives you all you need, honestly I don’t see a need in paying for those screens. I don’t pay for Finviz even though they have a premier thing where I believe you can do some extensive back testing.

Save your money and use if for something worthwhile, either if that’s investing in an education, buying books, investing books, get the classics, get my book if you want, or stocks. The screener is your first step, it is going to give you a list, and the whole point is to narrow it down and that give you something digestible that you can then use all the ratios that we’ve talked about previously. The analytical advantage that we have.

What I like about the VTI, is I can pull up an annual report, and within minutes I have a VTI number. Other people have their ways of looking at annual reports and scoring through them. I don’t worry too much about a stock screener being not accurate per se. Because I think it is going to give you the general picture and that’s going to be that important first step that gets you to the next step, which is going to be analysis. And start to build watch lists and narrowing down on stocks that you want to buy in the long-term.

Dave: Don’t pay for a stock screener when there are so many out there. You could spend that money on something like that could be better spent used for educating yourself, whether it’s buying Andrew’s book or any other opportunity that is out there to help you get better at what you are trying to do.

The numbers, again I use those as a reference point, I am never going to buy a company based on what Finviz tells me when I screen for them on a Monday. I will use those numbers as a launch point t start doing my investigation. I will read the 10-ks, I will typically and go back and read five years worth of 10-ks or more depending on what I see going on with the company. I know that is a little strange, and it can be boring sometimes, but it gives me a very, very good indication of what is going on with the company. I can see their relationship with the management, with the employees, I can see whether they follow through on their promises and whether strategic goals of the company and making changes or instituting new products or platforms are being successful. I can see all that, and that helps me get a much better view of the company, and it makes me a lot more comfortable with the company.

The accuracy of the numbers, I don’t worry so much about whether their debt to equity ratio is exactly on, again going back to what Buffett said, I am more worried about being approximately right than precisely wrong. I will use it more as a guideline. If it is a borderline debt to equity ratio then for example, which is a big one for Andrew and me, if it is borderline to me and everything else lines up with the company then I will do that calculation myself. I will go to the 10-k and look it up myself or go the quarterly and look it up just to get an idea of where they are going with that.

Because to me, that is more important, getting it from the horse’s mouth so to speak. It is more important that worrying about FInviz said specifically. A screener is just a way of trying to gather ideas, to find investment ideas.

What are your thoughts on small cap stocks and are they as fair game as everyone else?

Andrew: Yeah, stay away. I am glad you brought this up because one of the first things I will do when I run a screen is that I want to make sure I am getting at least a stock that over $2 billion or more in market cap. That gives me enough exposure to find the stocks that are not as widely followed by analysts, the small-cap space where there is still room for these companies to grow but again avoiding what you said these stocks aren’t traded with a lot of volume out on the market. There could be over the counter stocks, pink stocks. I don’t like those, number one they are at such a small size that they could be gulped up by a company who just tripped and fell on a bigger one.

On the other way, there is a lot more immoral and fraudulent activity that goes on in those types of companies. You have investment newsletter publishers that will pump and dump a stock. Profit from that big time. You have CEO and founders who will just prop up a fake company and steal shareholder money, and they’ll disappear in six months. You want to be careful with that and when you’re making a screen. I like to make at least sure I’m getting a market cap of $2 billion or more. I’ll admit having dipped my toes in some like $500 millions and maybe a $1.5 billion. But anything under $1 billion is risky.

Dave: The other part of that is those stocks tend to be incredibly volatile. Even though they may not be trading a whole lot, they can be so much volatility in that. And the farther down you go in the market cap, the more volatility you’re going to have. That to me is where I start to getting to scary stuff. I stay away from them, that’s just not my cup of tea, that’s not where I am comfortable.

Again going back to my buddy Warren Buffett, he talks a lot about working within your circle of competence and to me when I start dipping my toes and start looking at those types of companies it just to me feels like I am out of my depth and I don’t want to go there.

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