The Soufflé & The Sledgehammer
Tesla is not a stock we own, but a look at recent news shows just how different our investment approach is from that of speculators and fans of indexing.
Tesla CEO Elon Musk recently warned employees that if the electric-vehicle maker doesn’t meet its operating goals, the stock could be “crushed like a soufflé under a sledgehammer.”
It makes sense for him to worry. Speculators have driven the market value of Tesla higher than the combined value of the 12 largest global auto companies. Company profits are meager, and if they don’t grow fast enough, the stock could get walloped.
Who Cares About Price? Not the S&P Index Committee.
Despite this high price, the Committee that decides which companies to include in the S&P 500 voted to add Tesla to their Index. That means that investors who own index funds tied to the S&P now own it.
But isn’t the goal of investing to buy low and sell high? Why would the Index Committee add what seems to be an overvalued stock? Why would they continue to include other stocks that seem overpriced?
Well, because the stated aim of the Index Committee is to maintain a “representative” list of leading U.S. companies. They don’t make judgements about whether a stock is cheap or expensive.
Neither Do Index Funds
Index funds don’t make judgements about value either. They simply assume that prices are fair. Here is their investment process: Is this stock in the index we target? If so, buy it.
In contrast, we have a detailed, three-part test to evaluate stocks. We look at the quality of a business and assess the strategy and trustworthiness of management. We estimate the value of a business and compare it to the current market price.
So, Should Elon Worry About His Stock Price?
Fans of index funds would advise Elon to stay calm. The market has considered all relevant facts and has arrived at a fair price.
But markets are made up of people, and people are subject to swings in emotion. Prices can run far above what a cool-headed appraisal would indicate. This seems to be what Musk, founder and CEO of the company, is concerned about. And who knows more about a soufflé than the baker?
Add Half a Million Bucks to Your Savings: Read This.
You are likely much wealthier than you realize.
You get statements from the bank that show what you have on deposit. Thanks to recent transactions, you have a good idea of what your home or other real estate is worth. We send you regular reports that show the current value of your investment portfolio.
But you don’t see an asset value for the Social Security benefits you will receive. Instead, your focus is on your monthly benefit.
This makes some sense. Social Security benefits can’t be sold, so there’s no ready market value. Some things are unknown, such as how long you will receive payments.
Nevertheless, we can look at some examples to illustrate that future benefits have a lot of value. This has some big implications for how you view your finances.
In a recent post, we showed that at mid-year, the average monthly Social Security benefit for a retired worker and spouse was $2,301. If such benefits are received for 20 years, their present value would be $485,800. (Refer to the original post for details on our calculation.)
We also looked at the case of an individual retiring at age 66 who qualified for the maximum monthly benefit of $3,011. If received for 20 years, benefits would have a present value of $646,467.
Recognizing the asset value of Social Security benefits can provide some useful insights:
- Your assets may be larger, safer, and more diversified than you realize. Social Security benefits are a fixed-income asset with the highest credit quality. The ups and downs of the stock market don’t affect its value.
- Social Security is an annuity you already own. A fixed annuity is a contract in which an insurance company guarantees to pay you income over a certain number of years. People are drawn to them because they like the promise of guaranteed income.
- But this is an annuity without the usual drawbacks. But annuities are expensive, complicated, and force you to tie up your money for years. Social Security doesn’t have any of these drawbacks.
Why You Won’t See Us on CNBC
No one made the Forbes 400 list of richest Americans by following the investment strategies you see most often on the financial news network CNBC.
Network guests usually recommend stocks by using one or more of the following methods:
- Predict how today’s political/economic headlines will affect particular stocks. Load up on those expected to benefit.
- Buy if a company’s “adjusted earnings per share” is above consensus estimates.
- Follow the price trend. Buy stocks that are posting the biggest percentage gains in price. This often includes initial public offerings – IPO’s.
So, What’s Wrong with This?
- It’s high on entertainment value but low on what actually builds wealth. The common approach appeals to the gambling instinct of viewers. It’s a good way to get ratings, and is certainly more exciting than reading quarterly and annual reports, analyzing returns on capital, or assessing the merger & acquisition record of management.
- No one can make reliably accurate short-term forecasts. Even if it were possible to make good short-term forecasts, there are two problems. First, market prices may already reflect your prediction, in which case there’s no profit to be had from it. Second, what would your next move be? Let’s assume you successfully dodge a down day in the stock market. Would you know when to invest again and what to buy?
- Stocks eventually reflect business value. When liquidity is plentiful and the only thing investors fear is missing out on the next big thing, it seems unnecessary to think about risk. But times change, and stock prices have a nasty way of eventually reflecting business value. Those who focus on business fundamentals have an edge.
How Do We Invest, Then?
Building wealth means compounding returns.
Over time, the return on a stock will reflect the returns on the capital that’s needed to run the underlying business. The best businesses earn a high return for a long period of time.
We focus on finding these high-quality businesses, and we have a 3-part test that helps identify them.
In brief, we look for a business that’s capable of earning a high return on capital, is well managed, and is available at a reasonable market price. A lot of analysis is involved in each part.
Are There Drawbacks to Our Strategy?
- Being selective means we will miss some stocks that end up doing well. We look for opportunities in several industries, but we’ll avoid companies we can’t understand or that seem subject to unpredictable changes. Others may do well with some of these.
- We’re too dull to be on CNBC. They prize guests who can offer a seemingly expert opinion on any stock, but that’s not what we do. Our goal is to compound returns by sticking to the most promising companies we can reasonably evaluate.
Thank You for Referring Friends & Family
Many of you have referred us to friends and family for advice on financial planning & investment management.
We’re pleased to help, whether this means answering a question, providing services ourselves or pointing someone in the right direction.
If you’d like to discuss a possible referral, give Matt a call at 402-991-4818.
America First Investment Advisors, LLC is an independent investment advisor registered with the Securities & Exchange Commission (SEC). Find more information about us in our Investment Brochure on Form ADV, filed with the SEC. https://www.am1st.com/forms/ADV.pdf
Registration with the Securities & Exchange Commission is not an endorsement by securities regulators and does not indicate that an advisor has attained a particular level of skill or ability. Be aware that past performance is no indication of future performance, and that wherever there is the potential for profit there is also the possibility of loss.