In my view, most people who are selecting stocks for their retirement are doing it wrong. Most investors are picking “good companies,” stocks that have gone up a lot in the past, stocks of companies that are soon to release higher earnings, or stocks that have been selected because the technicals look good. All of these make for lousy long term investments. Here’s a better path to retirement bliss, one that’s much more likely to work out if you are prepared to put just a little bit of time and effort into your portfolio.
The original article has been edited here for length (…) and clarity ([ ]) by munKNEE.com – A Site For Sore Eyes & Inquisitive Minds – to provide a fast & easy read.
In my view, most people who are selecting stocks for their retirement are doing it wrong. Most investors are picking “good companies,” stocks that have gone up a lot in the past, stocks of companies that are soon to release higher earnings, or stocks that have been selected because the technicals look good. All of these make for lousy long term investments.
Take “good companies,” for example. I remember once discussing investing with someone on a Google forum years ago. He was bragging about how he bought Coca-Cola and how great of a company it was. He had held it for 10 years which, at the time, meant he bought it in 1998 or 1999. Looking at the chart it was easy to see that the company’s stock price had dropped meaningfully since then and had only crept back to and passed his breakeven cost 10 years later. He had made a compound annual 3%. That performance will not make for a great retirement.
The problem wasn’t the company, it was the valuation. Coke was widely regarded as one of the world’s best companies but it was trading at an enormously high PE of 61x. Put another way, if you bought the entire company it would have taken you 61 years to earn your money back on the investment.
Valuation is key when it comes to investing and, while the above scenario is bad, torpedo stocks are even worse. A torpedo stock is a rapidly growing stock that ends up devastating investors. These stocks always have a very positive consensus view leading up to the devastation — both pundits and investors think the stock and the company are going to keep on growing rapidly – but some hiccup in earnings or negative event occurs that disrupts that growth trajectory, leading to a massive drop in price.
Take a look at Taser International (now Axion) in 2004. The company had come out with a great new less-lethal product, the taser, and had secured some big contracts with law enforcement departments around the U.S.. The stock, which had grown rapidly in the years prior, surged up to $31.65.
Investors who bought the previous year were swimming in money but the company hit a snag due to poor publicity and serious questions about its product. Investor were no longer willing to give the company its enormous valuation, and the stock crashed to $8.61 a year later. Investors who bought at the peak when times were good and predictions enthusiastic lost -73% of their money. Investors who bought the year before even lost money. Are Netflix investors going to suffer the same fate?
Don’t Pay Today For Tomorrow’s Promises
The future is always uncertain, so it does not make sense to pay up today for tomorrow’s assumed growth. Instead, investors really need to protect themselves from unforeseen negative events. Ironically, there’s one technique that both protects investors against losing money, and sets them up for great long term performance: value investing.
…Over time the price of a stock will trade around its underlying value, and nobody can tell what the future holds with any certainty. In order to protect against unforeseen negative events, investors buy undervalued stocks and then wait for the price to rise to reflect value. Unless the underlying value deteriorates significantly, an investor is protected against negative outcomes.
The value of a stock is typically grounded in the amount of earnings or net assets the share represents. If a company has a book value per share of $10, and the stock is trading at $7, we have a bargain. If it’s trading at $700, it’s overvalued.
In terms of earnings, if the price of the stock is $7 and the company is earning $1 per share, the company is trading at a price to earnings (PE) of 7x. If the market as a whole is trading at a PE of 10x, we may have a significant bargain on our hands.
It’s worth noting here that most of the best investors — those with the best long term track records in terms of CAGR — are value investors. They’re constantly buying stocks for much less than they’re worth. It’s also easy for individuals to get into.
Go Deep Down The Rabbit Hold For The Best Results
While I love value investing, there’s a variant of value investing that produces the best returns on offer to small investors such as you and me: deep value investing.
- Deep value investing essentially demands a very large discount to a stock’s underlying value, and uses more conservative tactics to estimate a stock’s value.
- Rather the 30% discount cited above, I look for firms with a 50% discount or more. This means greater protection against unforeseen events, since a stock’s value has to deteriorate more before your purchase price is impaired. Conversely, my upside is larger, since the price has to rise more before getting back to the stock’s fair value.
- The catch is that you have to have a strong stomach to buy these firms because most of them are lousy businesses. Others have serious business problems, so investors have dumped the stock. While you may be rightfully cautious about buying firms that have major business problems, if you select using simple yet high quality criteria and diversify well, your portfolio will produce great long term returns.
…What strategies should you use to get started?
This is up to you, but you should probably start with Ben Graham’s final investment strategy on The Broken Leg. Not only was he the intellectual founder of value investing and achieved an outstanding record himself, almost everybody with a great record owes their success to his thought and teachings — even the legendary Warren Buffett.
Earning exceptional investment returns over the course of your life is not hard, but it does take the right approach and a solid strategy so start exploring…
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