Art and Science in Investing: Part II
The big earnings reports are mostly over, the S&P 500 is hitting record highs, and the holiday season is right around the corner. It's a good time to skip the commentary about the market's daily action, ignore what the president just said about negative interest rates (negative rates are ridiculous, have they done anything to help Japan or Germany?), and focus on some investment strategy.
On Monday, I talked a bit about investing "by the numbers." That is, you can start building a portfolio of stocks that will serve you well using simple metrics like the dividend yield. I called this the "science" of investing.
But I think once you get started, you'll have questions. There are 630,000 public companies around the world. And there are around 3,500 right here in the U.S. When you start actively investing on your own, you'll undoubtedly make use of the resources you'll find online. Most online brokers offer up some pretty good research. Yahoo! Finance is a pretty user-friendly resource, too.
Though with Yahoo! Finance, some valuation metrics are not reliable. You'll want to verify things like payout ratio. Also, the news flow at Yahoo! Finance is not comprehensive. In other words, if you use that site as your only resource, you will eventually encounter a stock that appears to be moving on no news, when it's really just that Yahoo! Finance hasn't picked that item up.
In any event, once you scratch the surface, you will find an overwhelming amount of information. There are many investment publications that talk about stocks like Investor's Business Daily and Zacks. There are more macro-type publications that feature economic and investing trends like Bloomberg and The Wall Street Journal. There are forums where individual investors tell you what they think, like Forbes and TheStreet.com. Then there are the e-letters for subscription newsletter services like The Motley Fool and Wealth Daily.
It is literally impossible to navigate all of it. You have to be able to focus on some information and let other information fall by the wayside. To me, there is art to this process. I'm gonna share some of what I've learned.
Change Is the Only Constant
A lot of stock-picking gurus will talk about "forever stocks" and "set it and forget it" portfolios. A warning about this: 40% of all publicly traded companies lost 100% of their value in a span of 35 years, between 1980 and 2014.
Sears, GM, Kodak — some of the biggest and best in the world went through bankruptcy. Some don't emerge.
Twenty years ago, GE was a marvel and had been for 100 years. But its forays into consumer finance nearly killed it during the financial crisis. And the missteps by former CEO Jeffrey Immelt choked off the post-crisis recovery.
This is a significant reason to keep your own portfolio on the small side. Something you can understand very well, review quickly, and for which assimilating new information is not a full-time job. Call it a "targeted portfolio," and people will think you're pretty damn smart.
You see mutual funds and hedge funds that have a couple hundred stocks. Probably the most recommended investment today is an S&P 500 index fund. Seriously? 500 stocks? That's your best idea?
You gotta wonder why this happens. I'll tell you: The stock picker is a dying breed. We're getting hunted to extinction by the financial advisor. I'll tell you straight: Financial advisors are basically salespeople created by the 401(k) world. They are "by the numbers" advisors that don't "do" individual stock research.
And as I said in the "science" part of this article on Monday, there's a place for investing by the numbers. But if you buy 500, you're buying losers, too, and you're not going to beat the market. Why invest in your 50 best ideas? How about the best 10, or 8?
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The Art of Ideas
There are plenty of successful investors out there who want to buy value. They screen the market for stocks that seem to be too cheap, that are overlooked or misunderstood. It's a fine way to go. Run your screening criteria, and you'll find 20, 50, 100 stocks that are very cheap...
Pore over the numbers, and you'll find the best values. But you can't invest in all of them. How do you choose? Besides that, stocks are often cheap for a reason, like the prospects aren't good.
But I much prefer what's called top down investing. Break the economy down into sectors, and it becomes much easier to manage. You don't even need help with that process because you have a brain and a bank account...
What do you spend money on? Food, clothes, car, gasoline, house, internet, cell phones, vacations, health care, and...?
That's nine sectors — not bad. You probably understand how they all fit together a lot better than you think. The S&P 500 only identifies 11 sectors. I bet it would take 30 minutes to find out which sectors have the best prospects.
Once you get a handle on which sectors have the best profit margins, best revenue growth, and brightest future, well, that's when the fun begins.
Let's take a quick look at electric cars, for instance. Huge growth potential, obviously. But it's still cars, and there is a very long history of car sales we can look at. Is an electric car revolutionary? Or is it an incremental change on an existing product?
I'd argue the electric car itself is an incremental change. It is not fundamentally different: It has wheels, doors, a steering wheel...
Ford has a profit margin under 5%. GM is about 6%. Daimler around 3%. Volkswagen 5.5%. And I saw a headline this morning that said Merrill Lynch thinks Tesla can get a 30% profit margin. Really? 30%? When every other car manufacturer is selling electric cars, too?
I think siding with 100 years of history is the way to go here. Tesla is unlikely to ever sport 30% margins.
Electric cars may not be revolutionary. But what the rise of the electric engine is doing to the fossil fuel market is absolutely a revolution. It's changing politics in the Middle East, it's capped global demand for oil and forced innovation to lower drilling costs — we're just beginning to see the impact. And I'll tell you: I haven't made very many investments in this direction because it is unclear to me who the winners are. Maybe it's just the lithium miners...
Genetic testing and genetically targeted drugs are going to be huge. Millennials are gonna buy houses one day. I still say Disney is the big winner in the online streaming space. It's up $5 today after Disney+ launched yesterday.
Art shouldn't be overly complicated. It doesn't have to change the world or start the conversation. It just has to look good to you. Jump in, trust your brain and your experience, and I bet you can do pretty well.
Until next time,
A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.
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