The aim of a rational investment strategy is to compound returns in order to build or preserve wealth.
No one disagrees with that statement. Yet, when we look at CNBC and the financial media, we see investment advice that is anything but rational.
What Others Do
From what we see on CNBC, the usual approach to choosing stocks looks like this:
- Try to predict how today’s political/economic headlines will affect particular stocks. Load up on those expected to benefit.
- Buy a stock if a company’s “adjusted earnings per share” is above consensus estimates.
- Find stocks that are posting the biggest percentage gains in price. IPO’s are often big movers. If experts predict additional gains, buy.
So, What’s Wrong with This?
- It’s high on entertainment value but low on what actually builds wealth.
Appealing to the gambling instinct of viewers is a good way to get ratings. It’s certainly more exciting than reading footnotes to company reports, analyzing returns on capital, or assessing the merger & acquisition record of management.
But a glance at the Forbes 400 list of the richest people in the US shows that none became wealthy by following the usual approach. Success comes from following a rational, focused way of doing things.
- No one can make reliably accurate short-term forecasts.
Even if it were possible to get a short-term forecast right once in a while, 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?
- It ignores that you’re up against well-informed competitors.
There are times when it seems easy to make money in the stock market. 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 value have an edge.
How Do We Invest, Then?
Let’s go back to the aim of compounding returns in order to build wealth.
Over time, the return on a stock will reflect the returns on capital earned by the underlying business. The best-performing stocks in the long-run will be from companies that earn the highest returns on the money that’s been invested to run the business.
Ideally, we want to own companies that can earn a high return on capital for a long time. We want to avoid those that earn less than their cost of capital, i.e., the minimum rate of return the market requires to compensate for investment risk.
We also like to keep portfolio turnover low so that taxes and trading costs are kept down.
Our 3-Part Test for Stocks:
We wrote a detailed post recently about our 3-part test for stocks. In brief, we ask:
1) Is this a good business?
Can we reasonably expect them to earn a high return on capital over many years? What are the key risks facing the company? Are there disclosures in the company’s financial filings that are a cause for concern?
2) Is management on our side?
What is their strategy and what is their record on capital allocation? Do their accounting choices suggest integrity or a desire to spin a flattering story?
3) Are shares reasonably priced in relation to our estimate of business value?
What have knowledgeable buyers paid for such companies in M&A transactions? What is the business value as determined by a discounted cash flow analysis?
Are There Drawbacks to Our Strategy?
- Having stringent tests means we will miss some attractive stocks. We find opportunities across several industries, but we’ll avoid those that seem subject to rapid, unpredictable changes in technology. Similarly, we’ll avoid complex financial institutions like money center banks.
- 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. We’ll occasionally strike out, but our batting average should be good because we wait for our pitch.
Barry Dunaway, CFA®
America First Investment Advisors, LLC
This post expresses the views of the author as of the date of publication. America First Investment Advisors has no obligation to update the information in it. 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.