Jack Bogle gave us the index fund. Warren Buffett has said most people should put their money into index funds.
Personal finance bloggers—especially in the FIRE* community—spout “index fund” like it’s a nervous tick. And you might have noticed this blogger has the same nervous tick.
Some are worried about all this index fund investing. The concern is index funds will control so much of the market that it will lose its efficiency. I remember the same concerns in the 1990s, when I was a stock broker, about mutual funds in general, most of which were actively managed.
Index funds will not break the market any more than actively managed mutual funds did. For one, there will still be plenty of people investing in individual stocks. And the hedge fund guys will do their share providing liquidity.
Index funds are automatic investing. All mutual funds and ETFs for that matter. You drop in your money (dollar cost averaging is suggested) and let time perform its magic. The broader based the index fund, the better your chances of enjoying the stellar performance of the market averages.
But some people don’t like “average”. And even the most hardened index fund investor periodically finds a company she would like to own a piece of directly.
That is where we come in today. Finding a gem that can add to your portfolio’s performance isn’t easy, but possible if you know where to dig. Many have made a career out of beating the market with thoughtful investments.
Index funds should be the home for a good chunk of your money. However, you might have a mad money account or even a serious money account for investing in businesses you feel are under-priced while possessing future growth potential.
Investing in individual companies can be very rewarding, but carry significant risks. I’ve been fortunate in finding great businesses that have performed well over the decades. My individual stock investments have outperformed the market. I’ve also noticed I think differently about an investment than most.
Today I will share why I buy what I buy, and more importantly, why I pass on so many opportunities that seem so obvious.
Buy the Hated, Be Leary of the Loved
Most people buy the hot stock because everyone is doing it and the recent price action has been tilted steeply up. These are the loved stocks. In the early 1970s they were called the Nifty Fifty; we now call them FANG (Facebook, Apple, Netflix and Google, the parent company of Alphabet) today.
Buying hot stocks is easy because everyone is doing it. That always causes me to pause.
For disclosure, I own one share of Facebook and a modest amount of Apple. I never owned any Google stock, but had a brief fling with Netflix.
Most loved stocks are priced accordingly. While I do own some shares of FANG companies, they are not predominant in my portfolio.
Let’s do a brief rundown of the list. Netflix is sporting a 134 price/earning (p/e) ratio as I write. While NFLX has a dominant market share and there are reasonable barriers to entry from competition, NFLX faces stiff competition from Apple and more importantly, Disney. NFLX doesn’t have to fail to drop significantly. If Disney captures even a small slice of NFLX’s business the stock is in trouble.
Google is also richly valued at over 40 times earnings. Facebook is a company I want to own, but management is concerning. FB has a dominant platform and not much in the way of competition. When FB dropped below 130 in December, the margin of safety was large enough for me to buy. But it was a modest investment.
Apple is a story we’ll address shortly.
I’m not saying there is never value in popular businesses. What I am saying is they tend to be over-priced. Warren Buffet once said he preferred a great company at a good price than a good company at a great price. Think about that for a moment.
NFLX and GOOG are excellent businesses, but are difficult investments to make at the current price. You don’t buy a great company at any price! You want to buy great businesses at a good price (or better) with plenty of margin for safety. Things do go wrong, you know.
Another area I tend to avoid are the socially acceptable investments. Everybody wants to invest in green companies these days. As a result, all that extra money is pushing these investments to levels too rich for this accountant’s blood. There can be select quality investments in this area, but none of it is cheap.
Since investing is about making money and not some ethical or moral statement, I seek value where others tend to avoid. Think of the most hated stocks: oil, coal, tobacco, processed foods.
I don’t own Exxon-Mobile (XOM), but I did take a look-see. As longtime readers are well aware, I own a lot of Altria stock, one of the largest tobacco companies on the planet. This is a good place to start our research on what makes a business worth buying.
Anatomy of a Good Investment
I think it was Warren Buffett who said, “It costs a penny to make and it’s addictive. What’s not to like,” about Altria (MO). In my opinion, Buffett would own a large slice of MO if he didn’t have a reputation to uphold.
Peter Lynch, in his book Beating the Street, shared his wisdom with a set of principles. Peter Principle #14 said: If you like the store, chances are you’ll love the stock. While Lynch is a legend in the investing world with a whopping 29.2% average annual return (better than Warren Buffett’s) when he managed Fidelity’s Magellan Fund from 1977 to 1990, there are times his principles are not hard and fast.
Take, for example, Amazon. AMZN is a great company with great management. I love the company and buy plenty of stuff from the platform. Unfortunately, the stock price is not so great. Buying even a great company with great management at nearly 100 times earning is a serious risk. AMZN is a great company, but probably not the best investment for me.
Which illustrates a point. I don’t smoke. Never smoked. But I do love MO as an investment. Their track record is unbelievable and they are doing it in a shrinking industry.
Still, my purchases of MO slowed these past few years. The price was a bit high for the situation and the 30 years of a declining cigarette market was starting to look problematic. True, MO has the world’s leading cigarette brand in Marlboro and are one of the best managed companies publicly traded. Management loves rewarding shareholders which is also a good sign.
The declining market size didn’t concern me the most; competition did. Peter’s Principle #16 says: In business, competition is never as healthy as total domination. I agree. And MO was facing serious competition for the first time in decades from a new foe: Juul.
Vaping isn’t exactly the most loved industry either. However, vaping was taking market share from MO and it was starting to move the needle. MO made attempts with their Nu Mark product to no avail. Juul was taking over the vaping market the way MO took over the cigarette market. And the regulatory environment creates plenty of barrier to new entrants.
What turned me the most positive on MO in my life was the 35% purchase of Juul. And the best part is vaping costs less than a penny to make and is also addictive. (MO also invested in a Canadian marijuana company.)
My greatest excitement with Altria is the potential size of the vaping market. When you review the numbers it is not hard to see Juul could be a larger company than MO. And more profitable due to the lower taxes on vaping products.
Excitement is not a good thing when investing! Boring is best because this is going to be a long slog. Patience is the most important quality when investing. I bought my first shares of the now Altria in the early 1980s. If you reinvested the dividends, MO was one of the best performing stocks of the last 30 years. And you enjoyed a couple of profitable spin-offs along the way.
Here are the things I looked at when purchasing more MO in December and earlier this year:
Is there an existential threat?
The massive investments MO made in late 2018 required review. The question has to be asked: If the government shut down Juul today would if put MO at risk of collapse?
After researching the issues it became clear the answer was “No”. If Juul went out of business MO would lose their $12.8 billion investment. But(!), this would not be enough to cause a dividend cut. Dividends would climb slower, no doubt, but the enterprise would continue. Also, if Juul disappeared, the people using the vaping products would probably turn to cigarettes for their nicotine fix, which MO has a dominant share of the market.
What about debt?
All else equal, I prefer companies with less debt. MO certainly has debt. The debt they issued to buy Juul will increase interest expenses. MO management said cost-cutting would be enough to offset the entire additional interest expense. Very encouraging.
An over-leveraged company should be avoided as the risks are too high. The balance sheet should provide all you need to determine the debt level the business has.
Everybody hates it!
MO’s stock took it on the chin as investors hated the Juul investment, at first. For a brief moment I was able to buy a great company in a hated industry that was hated by even its own investors. And there was nothing to warrant such a response. Yes, MO paid plenty for Juul. However, looking at Juul’s growth, the price will look like the steal of the century in less than a few years. So I backed up the truck. Now my dividends are even higher.
You do not need to be an accountant or tax professional to read a public company’s financials. But you do have to read them. Let’s take a look at MO’s balance sheet.
The balance sheet is the most important financial to review. (The cash-flow statement is a close second.) Income statements can be cooked, if you will. The balance sheet tells me how solvent the firm is. It also tells me if a recent investment creates an existential threat.
As you can see, MO has reasonable amount in cash and investments in other companies. If MO sold all investments in other companies they own for the price they paid they would have enough to retire all debt. MO investments in Juul and ABInBev are solid investments so they probably could sell these investment holdings at a profit. But we’ll discount some of these investments anyway to pad our safety margin.
When you review MO’s cash and investments against it’s debt and consider the shareholder’s equity, it is easy to see MO is not facing an existential threat due to their Juul investment.
One thing to note. The reason for the large negative number for Treasury Stock is due to share buybacks. This is not unusual.
A Few More Investments
As I noted in the beginning, I have a large share of my liquid investments in index funds. My retirement funds are almost 100% index funds or cash. My non-qualified monies (money in non-retirement accounts) are partially in index funds; a large portion is also in individual stocks. Buying good companies and holding them for a long time by default will increase the percentage not in index funds.
Apple is one of my newer investments. I will not provide financials as I did for MO. You can see Apple’s financials at CNBC.
I prefer buying when a company is on sale. December last year when the market was down ~20% had me buying heavily. APPL has been in my portfolio for years and I added to it. I never used their products so I didn’t know if I’d love them or not, but I am fully aware of the cult status Apple users feel about their Apple products.
APPL is a popular FANG stock so it might be something to avoid. Except, the stock price increase was accompanied by increasing earning, low debt, loads of cash and stellar management. Of all the FANG stocks, APPL has the best management team.
If you take the cash and subtract all debt, APPL still has ~$35 per share in cash! This means the p/e ratio is lower than listed. In other words, the enterprise has a 13.74 p/e ratio on it as I write. This is more than a reasonable purchase price for a company in a class by itself and a cult-like following. Though, I would prefer it “more” on sale before buying more.
Knowing When to Sell
Selling can be harder than buying. Even the world-renown Warren Buffett, who says his favorite investing horizon is forever, sells investments periodically.
Even your favorite accountant has sold a few shares of his beloved MO in the past.
Let’s take an example of why selling is different than buying. Buffett’s fourth largest holding is Coca-Cola (KO). He bought KO in the 1980s (if memory serves) and has held it since. The dividend is solid and growing.
If you looked at KO today (a hated stock because they sell sweet drinks bad for teeth and accused of causing obesity) you would probably take a pass. The company is awesome with an awesome product and solid management, however. KO is dominant in their industry. But where is the growth coming from?
KO has a lot in common with MO. People are drinking less fizzy soda water and the world population is no longer growing fast enough to power profits higher. Unlike MO, KO can’t raise prices as easily.
That said, If I owned KO I might not sell it. (I owned KO from the mid-80s to the late 90s.) The financials don’t excite me enough to buy a piece of the company. However, selling doesn’t make sense either. Selling would cause a serious tax bill if you held the stock a long time. And dividends like that are hard to come by.
When I sell it tends to be early on. If my original premise starts to erode I sometimes exit the investment. I bought Tesla and eventually sold. Of course I look smart because the stock was straight up at that time. However, my investment was more along the lines of keeping an eye on the company rather than a new serious investment position. The issue: Tesla without Elon Musk is in big trouble and they might be in big trouble anyway. I consider that a management issue in a very competitive market getting more competitive by the day.
When Facebook did a Faceplant in December, I bought. After considerable thought I came to the same conclusion about management and sold.
Like Buffett buying KO, I bought Aflac (AFL) in the B’C.’s (actually the early 1980s) and held it ever since. I haven’t bought more in longer than I can remember. The dividends are climbing and it has been a good investment with a very accomplished management team. I looked at AFL recently (for this article) to see if I should buy more. There are certainly reasons to buy, but not enough for me to add to my position.
Certain things will have me selling fast. Hints of accounting irregularities are usually a sign to exit. If new management is failing, I leave. (I owned GE once upon a time and sold all of it because I had no faith in new management after Jack Welch left.)
Patience is key to winning at investing. You wait for the right deal, then buy and wait forever as the business value keeps climbing. The stock price and dividends soon follow.
Finding a list of “hated” companies is easy. I want big, dominant companies in my portfolio. This reduces the chance of catastrophic failure. A good example is Boeing (BA).
BA is one of two major aircraft manufacturers in the world. (There are some smaller firms, but BA and Airbus control most of the market.) Recent crashes of Boeing 737 Max planes put BA under pressure. I bought a share so all the news stories would populate my feed. The stock started climbing so I thought I might not get a chance to buy at a “good” price. It happens. Most “watch list” businesses never become a real investment.
BA came down again, but not enough for me to buy. Personally, I like BA more than airlines. Buffett disagrees, but I’m okay with that.
Another watch list stock is JNJ. I owned JNJ in the past and I forget why I sold. (It was a dumb idea.) The recent asbestos in baby power/talc court ruling drove the price down. A little. Not enough to buy.
I’m watching Microsoft (MSFT) also. They really found their mojo after years where management struggled. I think Satya Nadella is a good leader at MSFT.
Of course, I own other businesses not discussed here. The idea is to give you the mindset necessary to win at investing.
Here is my final note: There is no crime is holding cash! Sometimes I catch heck when people realize I’m holding cash instead of investing in index funds. I can handle it. When the market is up I buy less because good investments are harder to find. When the market declines, like it did late last year, some businesses get discounted more heavily than others. Usually I find reasons to put my cash to work at those times.
Now the market is near a new high again and new money is still looking for a home.
So I wait. Patiently.
* FIRE: Financial Independence, Retire Early
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I’m going to start an investment company. Actually, I’m going to start a whole bunch of’em. Anyone interested in throwing in with the Wealthy Accountant? Read on if you think I am a good investment risk.
As an accountant I don’t want to leave anything to chance. People invest in firms with proven track records that exceed the norms. Therefore, my investment company will start several investments with only my money at risk. Several different strategies will be used to see which ones outperform. Underperformers will be closed without any investor money put at risk.
Before you start shedding tears for me, know I only invested a token amount into each fund. My loses were small and so were the gains. I just needed to know which ideas worked best.
Only the winners will be offered to the public. That means you, kind reader. Only the finest for those reading my blog.
Once the deadbeats are eliminated I can provide paperwork showing the wonderful returns on the winning investments. In fact, every investor from now on will see investments returns that include the numbers when the investment was really small and unavailable to the public.
Since the early, and unavailable to you, outperformance carries the same weight as the future returns when the fund is larger, the investment might have lost money overall and still claim a positive long-term return to investors. In other words, results are not weighted.
Oh, but the Wealthy Accountant knows future returns eventually catch up to a guy. So, I will close funds that take’er on the chin. Nobody wants to see that kind of thing in this investment company. Only survivors get to live on around here. For the laggards: OFF WITH THEIR HEADS!
Hey! Look Everybody. Darwin’s back
How many want to invest in my company now? Thought so.
First I salted the mine, if you will, by only allowing winners out of the test phase and then I killed the losers so you only saw outperformance. I look like a genius! I top the market by several percentage points after all those pesky fees I have to report in the prospectus. Call me Smarticus!
Survival of the fittest is the rule in the investment arena. Only outperformance is rewarded. To keep things going I will need a few baby funds in the incubation stage at all times in case too many in the public view take a shellacking.
Before you start insulting me, I never had any intention of misleading you! I had these great investing ideas and back tested them to see if they would work. Those working well on paper were taken to the incubation phase. Finally, the investments excelling in a real world situation were introduced into the world so everyone could partake of my intelligent investing skills. I would never ask you to invest in a loser. Fingers crossed.
As for the investments showing strain as the years roll by, well, you wouldn’t expect me to keep an old idea past its moment in the sun, would you?. You are my people. Only the best for you guys! When the numbers sour, out it goes!
Of course, I get paid fees for managing the investments. Nobody wants to invest in a loser so why should I waste my time on an investment not churning out enough fees for your favorite accountant. Geesh!
A Guy Named Ron
Earlier this year Jim Collins (jlcollinsnh), Carl (1500 Days) and I got together at Conclave to hammer out all the pressing problems of the world. Things have been a darn sight better ever since. Even the sun shines brighter. So it goes.
Two very intelligent women were there. The guys knew a thing or two, too. (Ah, who am I kidding?) It was a rainy Wisconsin weekend for our get-together. We enjoyed a Spotted Cow beer or three and talked shop. Very relaxing and informative.
When you have three personal finance bloggers in a room you can expect one to open his laptop and check his statistics eventually. When one goes, they all go. Call it a weakness.
Jim Collins is noted for his incredible work in his Stock Series. I highly recommend reading his work. Don’t worry! I’ll still be here when you get back.
On the last day of Conclave an interesting comment appeared on Jim’s blog from a guy named Ron. He seemed nice enough, but soon showed a thin skin. Before long you couldn’t help wondering if he was a paid spokesman for the actively managed mutual fund industry.
What Ron doesn’t know is I was in the room as Carl and Jim responded to him. I stayed out of the conversation online while we discussed among ourselves the best way to handle the painfully inaccurate comment from Ron. The worry was readers would see his comments and come away with false knowledge and suffer the consequences.
Ron had a love affair with American Funds. For a fund house of actively managed funds they are pretty good. Ron would not accept “good for an actively managed fund.” He was right and everyone else was wrong! He kept going back to past performance.
First, American Funds does have some impressive numbers. I have no idea how many funds made it out of the incubator or how much survivor bias plays a role. Not every American Fund investment outperformed, though some did by a small amount.
Fund performance rarely includes the load fee paid up front and sometimes also excludes trailing load fees with only a footnote for those who notice.
Ron’s argument actively managed funds are better than index funds is proven wrong by every broad survey of investment returns. Some actively managed funds do outperform their benchmark! With the number of funds out there it is mathematically very likely some will do that as background noise. It’s a statistical certainly a few will beat their benchmark by sheer probability. Still, there are a few that keep pumping out good numbers for a long time. Peter Lynch and Warren Buffett come to mind.
Past performance is not a guarantee of future returns. The outperforming manager of the last twenty to thirty years is enjoying his retirement now. The new guy has a much larger fund to navigate through the investment minefield. Plus, it is harder to outperform the bigger you get. By default a really large fund becomes a de facto index fund. By its sheer size it has to buy a lot of everything to stay fully invested or reasonably so.
Ron was wrong and he knew it. He is a smart guy running around the blogosphere preaching half-truths that put the less informed at risk. If Ron thinks actively managed funds do well he should see how some of the guys perform in their mad money account in personal finance blog arena. Some of those numbers are impressive. Ron would have to be impressed with double digit outperformance! But small accounts can do that a lot easier than any account of significant size. Probability dictates somebody will win big if enough play, like the lottery. Still, it’s a bad financial decision.
Follow the Breadcrumbs
Ron had no way of knowing the people responding to his comments on Jim’s blog were sitting together in a room and discussing their response. He also had no way of knowing I was also in the room. He had no way of knowing how concerned we were as a group how much damage he could do to a reader early in her journey toward financial independence. Ron could do real harm with his misinformation.
All that said it is no surprise Ron made his way to this blog with the exact same agenda. If he isn’t paid a huge salary by American Funds he is an idiot considering how much work and time he puts in plugging them.
I set the poor boy back. He only commented once and followed it up with an email. I have no problem with personal opinions in comments. Material misinformation is another story. Don’t tell readers actively managed funds are better without a link to a reputable source proving your point.
You know, I would have left Ron’s comment alone if it weren’t for my earlier experience with the guy on Jim’s blog. Poor Ron is upset with me and for good reason. However, this blog is here to help people, to make a difference in the lives of people who happen to wander in. An opinion here, even if I think it is wrong, is allowable. If I discover it is a pattern to mislead and misinform, I have a moral obligation to step in.
This blog is about money, taxes and financial independence. The road to success is straightforward. But there is room to wander a bit, too. Some things make no sense at all. Overspending, gas guzzling vehicles, high interest debt and a low savings rate are not part of this agenda. With rare exception, a very rare exception, actively managed funds might play a modest role in your portfolio.
If I had to choose an actively managed mutual fund, American Funds would be on my list.
But I still won’t do it and I have more than enough money to weather an actively managed mutual fund’s underperformance.