Thursday, May 30, 2019

Investing is part art, part science

I use a few quantitative factors in my investing including streak of annual dividend increases, dividend payout ratios, growth in earnings per share, and P/E ratios. I also use qualitative factors such as moat, competitive position, industry, product or service stickiness etc.

However, a lot of factors behind successful investing are dependent on the conditions present at the time you place your hard earned capital at risk.

For example, different companies and industries are available on sale at different times. Back in 2017 and 2018, we had a lot of REITs selling off on fears that the economy is slowing down and interest rates are rising. We had the same fears in 2013 as well. As I write this article in the middle of 2019 however, I find REITs to be a little pricey. And by REITs I am thinking about the likes of Realty Income (O), National Retail Properties (NNN), W.P. Carey (WPC). You have to be very selective in order to uncover good values in REITs today, and make sure that these entities are not cheap for a reason. Value traps can be expensive.

At other times certain industries end up being disrupted, despite having a long history of success. The newspaper industry comes to mind for me. There used to be companies like Gannett (GCI), which had long histories of annual dividend increases, up until having to cut dividends around the time of the Global Financial Crisis.

I am using these two instances as examples that things are never the same when it comes to investing. You can do a great quantitative and qualitative analysis of a business but can still lose money if the conditions are not right. The same principles that may have worked between 1999 – 2009 may turn out to not work as well between 2010 – 2019. As a result, you should always have some margin of safety built into whatever investment model you follow. After all, things may change despite our best efforts in the investment selection process. This is why you should still have built in redundancies in place in order to survive to fight another day.

I cringe when someone states that their investing model is based on science. Past performance is not an indication of future results. Overly relying on past data can be costly, because the investment environment in the backtest was different than the investment environment when your money is on the line.

You do not want to have an investment model that is based purely on past data, without taking into consideration the current environment. For example, a lot of investors may see historical information from a mutual fund and estimate that the future returns may be similar. However, if they forget about taking historical performance in a context, and misunderstanding the changes in the investment environment, they may be in for a surprise. If that mutual fund returned 9%/year by buying and holding treasury bonds between 1980 and 2010, that may have been because it was easier to buy bonds yielding close to 9%/year at the time. However, with long-term treasuries yielding around 3%, it is highly unlikely that an investment in treasury bonds will generate more than 3%/year.

I also see it to a certain extent with some retirees who believe that it is possible to live off a certain percentage of their stock portfolios in retirement ( say 4%). However, their dataset included periods when the average dividend yield was 4%. We know that dividends are more stable and reliable than stock prices, which is why dividends make ideal source of income in retirement. Dividends have only declined in a material way during the Great Depression of the 1929 – 1932. During the Great Recession of 2008 – 2009 dividends fell by 20%, which was nothing compared to the 50% declines in the broader market indexes. If capitalism is on its knees, only then do dividend payments suffer ( a third distant was the nationalization of equities from Russian investors in 1918).

Currently, popular US equity indices yield around 2%. It is possible to assemble a portfolio that yields 3% today if you are picky, but that is the best you can do today in the US in my opinion. Therefore, I do not believe that you can expect to “withdraw” 4% of your portfolio value under todays conditions. It may work if stock prices continue going up and you sell 2% of your holdings today, while generating the other 2% you need from dividends. Of course, if stock prices go nowhere, like they did between 1929 – 1954 or 1966 – 1982 or 2000 -2013, you may be in a little bit of a trouble if you have to sell stock for living expenses. Why would you be in trouble? Because you will increase your risk of running out of money in retirement.

There are a lot of academic models that discuss things like beta, alpha, covariance, optimal portfolios etc. However, I take these with a grain of salt as well. Academicians are great at torturing data, until they find something worthy of publishing in a journal. But their success in the world is not typically based on the performance of that model with real money. Smart people can be blinded by simple things, and may end up overcomplicating matters. For example, the geniuses at Long Term Capital Management had elaborate formulas to extract consistent profits for almost 4 years. However, they were overleveraged and their success depended on the the past being like the present. They failed, and inspired a nice book titled “When Geniuses Failed”. We are not geniuses, and our success in the real world is dependent on how our portfolios do, and how much reliable income they can produce to sustain us in retirement.

I believe that creating margins of safety, overlapping systems and different buffers can be great tools in the toolbox of the investor who wants to live off their nest egg in retirement. It is also important to have margin of safety in everything you do when in comes to investing. This means being diversified, making sure that there is an adequate payout ratio, that valuation is not overstretched and that no leverage is being used. It also means keeping investment costs low, sticking to your strategy through thick or thin and focusing on buy and hold investing.

This involves being diversified, buying blue chip companies at attractive valuations, buying over time. It may also involve generating income not just from dividends, but also from fixed income and pensions/social security. Owning your home outright may be another diversification tool, because you will need less income in retirement if you do not have a recurring rent or mortgage payment ( despite the fact that there is an opportunity cost in locking up your money in an illiquid asset that could be earning more elsewhere).

Going back to the point, I believe that it doesn’t make sense to have a list of great companies to buy at all times. The conditions to acquire companies vary from one period to the next. For example, my decision to buy 3M will be favorable if it is earning $10/share and selling for $150/share but unfavorable if it is earning $10/share but selling for $300/share.

In another example, I liked P&G (PG) until historical earnings per share were generally moving upwards. Due to the lack of earnings growth since 2008 however, it doesn’t make business sense to acquire ownership interests in this otherwise resilient business. In addition to that, it is selling at more than 20 times forward earnings. Therefore, it is a double-whammy. If P&G manages to resume earnings growth, and starts selling at 15 times earnings, I may consider it for investment again.

This is why as an investor, I try to buy stocks regularly, and picking the values I could find at the moment. If I do this for a long enough period of time, I would be able to buy securities from different sectors, by taking advantage of the sales being offered when different industries go in and out of style. This is a similar strategy to buying more when things are on sale at your local Wal-Mart and buying less of other items that have recently been marked up. It intuitively makes sense that as an investor in the accumulation phase, I am excited to see when stocks are down in price. This means that future retirement income is on sale.

Relevant Articles:

Margin of Safety in Financial Independence
Another reason for companies to pay dividends
My Entry Criteria for Dividend Stocks
Diversified Dividend Portfolios – Don’t forget about quality

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