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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Friday 20th of September 2019
Keith, I'd be interested in hearing your thoughts, do you still hold the same position on MO stock with the current situation of FDA pressure on JUUL due to vaping related deaths and the plans of the Trump Administration to prepare a nation-wide ban of flavored e-cigarettes? Since the original writing of this article MO's stock price has been taking a hard hit.
Friday 20th of September 2019
Evan, investing in companies that trade publicly always means there will be illogical pricing (high or low). I have added to my MO position this summer and will continue to do so unless something "real" changes. I am publishing an article on MO at Seeking Alpha shortly dealing with the current issues surrounding the company and industry.
Every vaping issue is called a Juul the same way every photocopy was once called a Xerox. None of the health issues have been connected to Juul and it seems all cases are linked to illegal street products, especially those linked to THC. But that isn't the headline.
If (and they will) they make flavored pods illegal the black market will grow faster than it already has which will cause more health issues. The long game is flavored vaping will return at some future date so large regulated companies are providing the product. Regardless the vaping flavor/health risks issues, vaping is here to stay: legal or illegal. Government knows prohibition never works. Legalize and regulate does. They'll get there.
Vaping has been around a long time (1940s in China I think). It only got real popular recently. No death or even serious illness has been attributable to vaping until the past few months. So what changed? Illegal street vapes.
Once the hype passes Juul and MO will both be fine. Besides, how many who return to cigarettes from vaping will die?
What started the issue was former FDA commissioner Scott Gottlieb. Gottlieb talked tough on tobacco when it seems he was really working to line his own pocket. As vaping started to accelerate the decline in tobacco use Gottlieb's talking point was dying fast along with a massive personal money opportunity: a seat on the board of Pfizer.
Pfizer makes smoking cessation products like Chantix. If Gottlieb killed tobacco too fast or another product cut smoking Gottlieb would find it hard to get a seat on the Pfizer board. So Gottlieb had to attack vaping. Yes, this is a serious conflict of interest. It should be interesting how it plays out.
Cigarette use will probably climb for a short while (good for MO profits) until the vaping crusade dies down.
As for financials: You do realize MO is more than a Juul investment? MO also owns 10.1% of BUD worth over $16 billion on the open market (significantly more than the Juul investment). This equates to over 20% of MO's current stock price. Even if all MO investments, except BUD, are worthless (Juul, iON!, CRON), MO is still the cheapest tobacco company out there, trading at about 7 times forward earnings and paying all their dividends from profits.
I had a hard time investing in almost anything a few years back, Evan. Even MO was in the 70s. I buy companies on sale or keep the cash in my pocket. MO is on sale and as with any investment, there can be short-term pain. But does anyone really believe a business they buy will always be priced higher than the original purchase? The good news is you enjoy an 8+% dividend yield while you wait for the dust to clear. Even if everything falls apart for MO, they still have what Warren Buffett used to call his cigar butt (apt analogy in this case) investments. MO will pay you back 100% of your investment in around 12 years in dividends if they never raise the dividend again. The odds are dividends keep climbing so the payback is even faster. Cigarette sales are in decline as they have been since 1952. Still, a lot of tobacco still gets sold. Therefore, the dividend looks secure to me with more increases over the next many years.
And if the investments work out things could go really well.
What does worry me is the merger talks. I need details on that before passing judgement. I play the long game so I sit quietly and wait. I've seen this all before. You should have saw the price action in the 1990s when the settlement was handed down. It was the end of the world for tobacco until is wasn't.
Triple Fi Guy
Tuesday 16th of April 2019
It appears we all missed out on America’s top performing stock this century at a gain of over 60,000%!
Anybody have any ownership of MNST?
Monday 15th of April 2019
Great article! I think it would be great if you did a series on this going into more detail.
To start with, what information do you pay attention to that provides you with the companies that you decide to dig a little deeper and analyze the financials as you did with MO in your article?
One problem I find I have is that I read an article on a certain company or stock, and the case is made in pretty convincing fashion as to why the stock is a buy. I will admit to buying several stocks based on these articles. I have done OK with those stocks. But, a lot of stocks have gone up in the past couple years. I know this is not a solid investing strategy though.
So, I would love to hear how you find out about what stocks and companies that you want to do your due diligence on.
Regarding the Microsoft stock. How much farther would it need to go down for you to decide to buy? What platform do you use for trading? Does that platform send you alerts if a stock drops to a price you are willing to buy at?
Thanks as always for all you do! Keep up the great work!!
Monday 15th of April 2019
I can answer from my perspective, but would also like to hear Keith's.
I get investment ideas from Seeking Alpha, the WSJ, news in general, and daily life observations. I have analyzed a lot of businesses at this point, and so that accumulated knowledge also creates some adjacent ideas.
I will say that I don't pursue every company that seems interesting or attractive. I tend to continue adding to what I already own when those prices are reasonable. My core holdings each make up about 3-7% of my overall portfolio, and so I am a proponent of concentration (not diversification). Use your index funds for diversification insurance. Avoid sprinkling your cash around in too many disparate businesses, and instead find a few that you are very comfortable investing in (that are priced well).
I like to gather company financial data and create spreadsheets that organize this data. Then I keep them updated, and use the sort features to narrow down my choices when I have cash. So I may add companies to my spreadsheets and/or lists, but may not make any moves for months (maybe years). I look at investing as a bunch of opportunity costs. I may like this or that company, but if there are more attractive options in stocks I already own or elsewhere I will continue buying them instead.
Microsoft is way way ahead of its ski's as to the price. It is a really great business with a close to perfect A credit rating. It mints money, has plenty of cash, and pays a dividend to reward patient shareholders (not speculators on the price). Management has greatly improved. The price! My god the price of this beast. By every measure, MSFT should produce exactly 0% returns over the next 5 years, as all their earnings growth and discounted cash is already in the stock (and then some). Yet, perhaps it was simply way way undervalued for many years (it was). So how do we square this circle?
Microsoft today trades with an "earnings yield" (earnings divided by price), of 3.6%. That means essentially that you are accepting a 3.6% shareholder return on today's earnings. These earnings will rise in the future, but the stock price will HAVE TO rise much slower than earnings in order for this return to be more in the range that investors require (something more like 7-9% earnings yields). If you can buy MSFT today and earn 3.6%, perhaps you can find a stock with an A credit rating that promises a better return? You can buy Apple today for an earnings yield of 5.7%, and their financial position is similar.
It's all about trade-offs. This or that?
My favorite ways to look at a business' valuation is to look at: - earnings yields (this is the implied return on current earnings today) - historic p/e vs today's p/e - compare to the broad market earnings yield and p/e (use the website mltpl.com for this information) - historic dividend yield vs current yield (yields tend to revert to the mean just like earnings and stock prices)
I only look at these metrics once I have identified a great business that I can wrap my head around and be comfortable buying. I use these metrics to put everything into a spreadsheet so that I can sort the sheet to compare them against one another. Since the entire market is a giant weighing machine, you can use this to weigh your odds and safety margin. Find stocks that are trading well below your required return rate, below historical average dividend yield and earnings yield, etc. Buy those companies above the rest.
Monday 15th of April 2019
Clay, you have a lot to unravel in your comment. At some point I may produce a course along with articles taking a detailed look at how I find potential investments and what triggers the exodus from my wallet to ownership of a faction of a publicly traded business.
As for MSFT. I sold some 75 strike puts last December expiring in a few days. I get to keep all the premium, but have no ownership of MFST. In hindsight I should have picked up at least a token amount of MFST when it was below 100 for a brief time. Instead I sold options which gave me an immediate gain, but no long-term growth from ownership. In my opinion, anything under 100 is a buy for MFST and 75 would be a screaming buy. That may never happen unless the market has another fear-fit. I'll wait patiently. Also keep in mind the value of MFST climbs as they grow their businesses. Same goes for MO. Anything under 60 (for MO) is an easy buy for me. Still like up to 65 and would cautiously buy up to 70. Then again, if MO starts growing faster and Juul turns out to be what I think it is I would be willing to up my buying price. (For the record, I made another small buy of MO today.)
As for platform; I use E*Trade. I buy 1 share (or 10 or so) as a way of keeping an eye on a company. Every time I open the account I see news on all the companies I own. I also use CNBC a lot when researching and just for a casual review of the market. Specifically, I'm looking for companies punished for some misdeed or mishap more than they should have been. Example: If BA has another round of fear, driving the share price close to 300 I will probably be the proud owner of a fractional share of BA. I'll also probably die holding those shares, living off dividends if the need ever arises.
Monday 15th of April 2019
Thanks for the visual on the balance sheet! I always find them so intimidating and will have to review your example when I have more time, so that I can become stronger at analyzing stocks - it's something I've wanted to learn more about. I've purchased individual stocks in the past and still hold several. Overall, they have served me quite well and I have no problem with them. I'm sure I'll purchase more in the future. Previously, I watched what people were buying en masse and purchased stocks accordingly -- AAPL is one example. But this isn't the method I want to continue using, since I'd prefer being a more informed investor, so thanks for breaking down your thought process! I agree that the lesser knowns are likely the more desirable stocks as well.
Sunday 14th of April 2019
I also love index funds and ETF’s and do not believe ownership is mutually exclusive to actively buying individual stocks.
Great minds think a like.