Core Investment Strategies to Earn Superior Returns

Now that we have laid some groundwork for what we are looking for in good investments, I think it is time to go into the overall investment strategy that we will employ to earn excess returns.  To summarize from our previous posts on indexing, the Fama and French model, and past successful super-investors, we want the following qualities in ourselves, our portfolio, and our individual investments:

1. Have an investment philosophy that is rigorously adhered to through thick and thin, that is based on sound principles.  We may learn things along the way to modify our investment philosophy, but these should be weighed very carefully before making a change.
2. Have courage of conviction – once a stock is selected according to our investment philosophy it is intended to be held indefinitely, or until the underlying business changes in a manner that is no longer consistent with our investment thesis for the company or our investment philosophy.  This means being able to hold a company that is down 50% or more as long as the underlying business is still healthy.  It also means being able to let a loss go if the underlying business has deteriorated permanently, however. Buy and hold forever – not buy and sell, should be the default position.
3. Don’t invest in things you don’t understand.  Investing in a fancy new gimmick or stock with complicated moving parts that you can’t understand is neither desirable nor necessary.  Maintain discipline and invest in things where you can understand how they make money.  For many of the best companies, it is easy to identify the logic of how they make money.
4. Be patient – harbor no desire to gamble or chase get-rich-quick schemes.  Recognizing that compounding earnings are very powerful over time and will beat all of the people around you who are investing in the latest fad and bragging about getting rich, only to lose it all soon after.
5. Avoid market timing.  As tempting as it is to try to hold cash for a future market downturn, or try to sell it all at the top, avoid this.  It increases portfolio turnover, taxes, and you will usually be wrong.  95% of the gains in the market happen in something like 5% of the time.  If you are playing around with market timing, you will likely miss these opportunities.  Add to that, dividends come every month, quarter, and year.  You will miss out on these dividends by not being invested.  Lost time is opportunity cost.
6. Maintain money discipline to save and invest.  Focus on saving and/or earning more money to invest.  Invest diligently every month, realizing that time in the market is more valuable than timing the market.
7. Have extremely low portfolio turnover.  As Warren Buffett said, the preferable holding period for a good investment is forever.  You should strive to sell almost none of your holdings as long as the underlying business does not reach extreme overvaluation or as long as the underlying business is still viable. You should not constantly switch strategies and companies leading to portfolio churn.
8. Maintain adequate diversification, but over-diversification is not necessary.  It is not a good idea to own fewer than 5 companies in your portfolio, although some have done this successfully with extreme blue chip companies.  Similarly, it is not a good idea to own 50 crappy companies as we discussed with steel mills in the previous post on indexing.  You will naturally increase the number of companies you own as you purchase and rarely sell throughout your life, however.  The difference is that these all should be very high quality companies.  It is best to start out with between 5-20 companies and then not worry about this too much as long as the number of companies doesn’t get too low or a few companies become an outsized percentage of the total portfolio.  We will discuss this more in a future post.
9. Develop some financial acumen, so that we will be able to assess things like quality businesses and value obtained relative to price paid.
10. Engage in value investing – obtain assets and cash flows that are high relative to price paid.
11. Engage in quality investing – buy businesses that have very high earnings quality, pricing power, and high and sustainable returns on invested capital.
12. Minimize taxes – as your portfolio grows, taxes will eventually become a major expense, if not the largest expense in your life.  You must maximize after tax returns on investment, as these are the only kind of return that matter in the end for you.  This means managing which investments are bought in taxable vs. tax advantaged accounts, and maintaining extremely low turnover.  We will discuss tax minimization strategies quite a bit in later posts.

Now that we have some investment principles to follow, let’s put together an investment plan.  Because many of you will fall under all ranges of financial acumen, willingness to work on investing, time to be able to look at investments, behavioral temperaments, etc., I have put together a 3 tier plan for investment strategy.  You will select the strategy that suits you based on your ability, behavioral temperament, and willingness to put in additional work.  Higher returns are expected from putting in more work and understanding, however.  The three tiers are 1) index investing, 2) dividend growth investing, and 3) building your own shopping list of high quality stocks to invest in. All 3 tiers will be index-like in their investing strategy – buy and hold, low turnover, etc., but the difference is essentially in whether you buy an available index, or construct your own.

Index investing

The first and easiest strategy for those who don’t understand finance, is index investing.  You guarantee yourself the average return of the market, with minimal effort.  Behaviorally, it can be a great strategy for those who would stay awake at night worrying about a market crash or an individual stock in their portfolio doing poorly.  The more you worry about ups and downs, the more you would need to accept lower returns in your portfolio to have a smoother journey upwards (but note a smooth journey is never guaranteed even in that case).  You pick a risk level by selecting your bond allocation.  For very young people and those behaviorally able to handle volatility, you might pick a portfolio composed of 80% stocks and 20% bonds.  For those nearing retirement, and those who would worry themselves into selling prematurely, you might pick a 50% stocks 50% bonds portfolio.  From there, we can choose what type of indexes we want to include.  Typical configurations are:

1. 3 index portfolio – total US bond market, total US stock market, total international markets excluding the US
2. 4 index portfolio – add to the 3 index portfolio one of: emerging market stocks, real estate stocks / reits

Configurations can get more complex from here.  You can segment bonds into corporate bonds, US treasuries, international bonds, etc.  You can add things like commodities which have low correlation with the stock market, and so while the commodities themselves don’t grow very much over time the rebalancing bonus you get from them earns a greater overall return.  You can get into 5, 8 or 10 index portfolios, but you probably will capture most of the gains by going with a 3 index portfolio above.  Most importantly, remember that you should pick a strategy that is easy for you to implement and that you can stick with for decades.  If it is too complicated for your personal style, you won’t follow it very well after just a few years.

Once you pick an index investment plan, you decide your porfolio weights.  So, for example, a young person might choose 20% total US bond market, 60% US stock market, 20% international markets excluding US.  Every so often (quarterly, yearly) you will rebalance towards these targets.  Yearly is usually good enough, and is simpler to implement. So, for example, after a year, some things will grow and some will decline, such that your new portfolio weight is 15% bonds, 66% Stocks, 19% international.  You then can rebalance them to the 20%/60%/20% weightings, and rebalancing will have the tendency to sell the more highly valued and purchase the more undervalued over time.  This will earn you a rebalancing bonus.

If all of this is too complicated, you can always buy a target retirement date fund.  It will invest in a bunch of indexes and do all of the rebalancing for you.  If you plan to retire in 2040, you might select a 2040 target retirement date fund, and just buy in every paycheck.  These are often available in 401k plans and other common workplace retirement plans.  Index investing, as you can see, can be simple, but can also get complicated fast.  You can learn a lot more over at bogleheads.org if you wish.  I personally would go with a target retirement date fund or do an extremely simple 3 fund index investing plan.  If you are going to put in more effort than that, you might as well graduate to the next higher tier of investing – dividend growth investing.

Dividend growth investing

About 40% of the S&P 500 returns have been in the form of dividends since 1930.  Companies that pay steady and rising dividends over time without dividend cuts are more likely to have higher earnings quality.  The reason is that if the cash is not there to pay dividends, the company would quickly run up debt and eventually run out of funds to pay dividends if it didn’t have a business that generated the cash to do so.  Many shenanigans can occur on financial statements that can be concealed, but cash in your hands doesn’t lie.  Said another way, if the cash isn’t there, we do not care.

Companies that pay out increasing dividends year after year reliably and without any dividend cuts are probably high on quality unless there is a recent new development that hasn’t yet been reflected in the dividend, or unless they are overextending themselves to maintain their dividend.  Wouldn’t it be great if there were a list of companies that have paid steady rising dividends over many years?  Well there is!   The Google spreadsheet at this link contains all of the champions (>25 years of rising dividends), contenders (10 – 24 years of rising dividends) and challengers (5-9 years of rising dividends). 

Using this metric, these companies in aggregate are likely to be quite a bit higher in earnings quality than a set of randomly chosen companies.  The spreadsheet also includes additional screening metrics like return on equity to help in further selecting stocks.  With dividend growth investing, you can go one of two ways.  You can buy a bit of many dividend champions.  Or, as I would recommend, with a bit more work you can screen the list for low valued companies (looking for low price to earnings, low price to cash flow, high dividend yield, or low price to book, for example).  You will likely (but not certain – nothing is ever guaranteed) earn a good excess return over simple index investing if you use this as your shopping list of companies and add each month by buying companies from this list in that happen to be in the good valuation range at the time.

Remember, you must invest in an index like fashion though.  You should maintain extremely low turnover, rarely sell, and add to your investments each month.  Because you are in a truer sense, loading up on stocks in a value and quality weighted fashion, you are likely (but not guaranteed) to outperform a market cap weighted index that has a more naive selection of value and quality (or no selection for value and quality at all).

Star List Investing

The final method of investing is reserved for those willing to put in the work, having good financial acumen, and having a behavioral temperament suited to this kind of investing.  For this kind of investing, you will develop a shopping list of the highest quality companies.  These are companies that if you had to invest in today, and you couldn’t come back and look at your portfolio for another 50 – 100 years, most of these companies would survive in some form or another (despite mergers, and spinoffs, etc.).  And of those few that didn’t survive, they would probably generate enough value before dying to earn multiples of the initial investment in that time in the form of dividends, spinoffs and the like.  These companies have durable returns on capital that will not be eroded with competition over time due to having some special something – knowledge, patents, trademarks, copyrights, outstanding management, etc.

To be clear, these companies are extremely rare gems.  Out of a universe of 30,000 or so publicly traded companies, the Star List developed together by the authors of this blog has managed to find only about 100 companies total that fit the bill.  This was after screening companies many, many different ways, looking through lists of thousands of companies, and reading thousands of annual reports over the last 10-15 years.  So, we have been looking under every rock for these rare companies.  I have looked everywhere I can think of, and continue to look for these companies.  But a company that is worthy of being included on this list is rare.  There are some blue chips, but believe it or not, there are quite a few blue chips that don’t look so great when viewed through this rigorous lens.  And yes, there are a few gems to be found in companies that are not considered to be standard blue chips also.

So how do you develop such a list?  Start with narrowing down from companies on the dividend champions, contenders, and challengers that I provided in the link above, of course!  These companies are pre-screened for earnings quality.  You can expand your list later on, as there are also plenty of very high quality companies that don’t yet pay dividends, but you can look for those a bit later after you develop the skills for finding them.

You will have to deep dive into each of these companies you find, looking at earnings quality, industry or company specific risks, competitors, management etc.  We will devote a large part of this blog to techniques for identifying companies of this caliber.  More importantly, we will develop techniques to exclude companies from this list that could cause trouble down the road, even if they look good now.

Our shopping list is developed independent of valuation.  We are not looking yet at which companies are bargain priced.  Sooner or later, most companies dip into bargain territory.  You want to be ready to swoop in and buy when they do, but until then, you still want to have the company on your shopping list to buy, so don’t exclude companies from your list based on valuation. 

Often, you find many of these high quality companies will be overvalued at the time you identify them.  Once identified, you will develop a valuation metric to track which companies are cheap relative to the others.  My personal favorite quick valuation metric is stock price divided by a 3 year or 7 year average free cash flow.  3 year free cash flow is ideal for higher growth companies, since you don’t want to mask the growth by averaging too many past years, but at the same time you don’t want a one-time gain that won’t happen again throwing off your valuation metric too much.  A 7 year free cash flow is more ideal for cyclical companies (like oil companies) that might have some growth, but are also heavily dependent on business cycles.  A typical business cycle is 7-10 years, so a 7 year average free cash flow averages out one business cycle quite nicely without masking underlying growth too much. 

Now, once you line up all of your companies on your preferred valuation metric, and you know that all of the companies in your list are of extremely high quality, you can worry about buying the best deals on your list each month.  Over the years, the best deals will change and you will naturally build a portfolio of a number of companies.  Keep in mind that you want to invest in an index-like way using this method.  You want extremely low turnover, you want to rarely sell stock, and you want to put money into these stocks consistently in a value weighted manner.  Just the fact that you add stocks in a value weighted manner instead of a cap weighted manner as in an index fund should get you an outsized return.  Add to this the ability to tax optimize in a way that index funds cannot (for example, by adding less tax efficient securities to your retirement portfolio and more tax efficient securities to your taxable account) and you will really blow away the index investing method.  Add to this the fact that you are loading on quality in a way that indexers cannot because they cannot analyze for true quality or value – they only use rough proxies for these measures instead of a holistic analysis. In addition, indexers aren’t that selective – they have many hundreds of stocks in their index. Taking all of these factors together, this method should likely be earning superior returns to vanilla indexing.

I believe this method will earn outsized returns over time and it is the method I practice.  I like to have a pre-screened shopping list like this, because it allows me to be ready to jump on a deal when one of the companies I am interested in goes on sale.  I call this method Star List Investing, because you are looking for the star companies to add to your shopping list and to your list of purchases each month.

Those are the 3 methods of investing from low to medium to high effort.  The more effort involved though, the better the return.  In future articles, we will look at techniques for improving the returns of each of these methods of investing as well as the implementation of these methods.  For the near term, we will examine quality companies more, and focus on the method that we believe will earn the best returns – Star List Investing.  The aim is to give you all of the tools you need to develop such a list of your own.  We will get started on this over the next few posts.