Investing Should Be Simple

Investing should be simple, and conceptually it is however in practice things get a bit more complicated. So let’s talk about why investing should be simple, why it isn’t, and how you can simplify the chaos that is the stock market.

Investing Simplified

The secret to being a successful investor is that there are no secrets. You invest in the right company at the right valuation and over time your investment increases in value. You repeat this process and over a long enough period of time it will generate wealth. Conceptually this is all very easy to understand. However in practice investing can be very complicated. Which company is the right company? What price is the right price? And how long do I hold my position? Even if you can figure out the answers to these 3 questions, and in theory get it right, your investment may not materialize as expected. The stock market isn’t always efficient and investors can lose money investing in great companies. I’ll touch on why that is a little bit later.

Here’s the most basic 3 step outline for how you should invest.

1. Find a high quality business

2. Determine if its future outlook is strong

3. Figure out if its reasonably priced

If you can find a stock that meets all 3 of these points all that is left to do is invest and patiently wait for a rewarding return. And you should hold this position for as long as you believe points 1 & 2 are still valid.

Investing should be simple. You should be able to answer why you believe a given company meets all 3 of these points without performing any complex analysis. Let me unpack each step, one at a time, and tell you how to easily review any company with this process.

High Quality Business

The first step is finding high quality businesses, this is by far the easiest part of the process. While there are 10’s of thousands of publicly traded companies, today we have access to robust free screening tools that can help us narrow in on any subset of this universe. It’s far easier to find businesses that are already great opposed to trying to figure out which new company will go on to be great. The latter may be a more fruitful avenue to pursue but one that is substantially more difficult.

So what does a great business look like? Well, it should:

• be growing its revenue

• generating a healthy return on capital

• have strong margins

• a solid track record

To find such businesses we can apply the following screening criteria.

• 5 year revenue growth rate of at least 5%

• Return on Capital Employed (ROCE) of at least 20%

• Gross Profit Margin of at least 30%

• Return Since Inception (CAGR) of at least 12%

You can screen for these metrics using the free screening tool found on finchat.io. I ran this screener on 7/24 and it showed me 119 companies that met all of these conditions. I also filtered for stocks that trade on the NYSE and NASDAQ since I’m a US based investor. You can set your own exchange filters depending on where you are in the world.

If you’re a dividend focused investor you can add the following 3 metrics that will trim this universe of stocks down to 53.

• Dividend Yield greater than 0.01%

• 5 Year Dividend Growth Rate of at least 5%

• Payout Ratio lower than 80%

53 or 119 companies is a manageable list to work with. You can sort or further filter this list down if you’d like, to help you figure out which company you should review first.

In theory all or most of these companies should be great businesses. Of course further due diligence is necessary to verify that these business are in fact growing and maintaining their metrics. This can easily be done on finchat.io by spending a few minutes looking at each company and their financials.

Future Outlook

Once you have a shortlist of great companies the next step is to figure out which, if any of them, have the potential to continue growing in the future. This is a little bit more challenging. I like to start my review by reading the most recent 10k for each company. No, I am not suggesting you read the entire 10k report. Spend 20-30 minutes skimming the report, reading certain sections, with a goal of trying to better understand how the business operates and what management is predicting for the future. Which areas of the business is management investing in? Are those segments growing? And most importantly do you think this will be a thriving part of the economy in the future?

I know these are tough questions to answer and you may not be able to do so with a high degree of confidence for many companies. The good part is that you don’t have to. If a certain company is too hard for you to understand or you’re not sure what to think about its future, simply move on. You have a shortlist of 119 (or 53) companies to review and you don’t have to invest in all of them. Its highly likely that you’ll pass up some great opportunities simply because you are unable to understand the business or its future potential. That’s okay. Baseball players pass up a lot of great pitches looking for the right one, yet they still hit a few home runs. Investing is like baseball expect there is no 3 strikes and you’re out rule, you get an unlimited number of pitches.

You should also accept the fact that some of the companies you do select will go on to fail. It may be a great business and the future outlook may look bright but businesses fail all the time, even ones that have a solid past. If you can win 6 out of 10 times you’re going to have one heck of a great investing career.

Reasonable Price

Once you get past the hurdle of identifying a great business and you do your due diligence to make sure it is a solid company with strong future prospects, the toughest part of all is determining the right price to pay. I’ll preface this with the fact that even if you overpay for a great business that turns out to have a strong future your returns will only be marginally impacted. Rephrasing Buffett’s famous quote “it’s far better to buy a great business at a fair price than to buy a fair business at a great price” as “it’s far better to overpay for a great business than to buy a crappy one at a discount.”

The average investor spends way too much effort trying to precisely value a stock when at best you’re probably going to be pretty wrong anyway. Valuation is more art than science because the science part is way too complex for us to measure. Building complex discounted cash flow models take a very long time and lot of effort and in the end it comes down to getting one input right, accurately predicting the rate at which a given company will grow over the next few years. Thinking that you can do this with a high level of accuracy is foolish.

Given that valuations are so difficult to get right it only makes sense to spend less time putting them together and instead of aiming for precision aim for reasonableness.

For example, instead of putting together a discounted cash flow model try using the reverse discounted cash flow model. Its far easier to put together and requires no assumptions. The output tells you the rate at which a given company must grow its cash flow for the current price to be reasonable. So instead of trying to figure out what the growth rate will be in the future, you are left with the question of whether the imputed growth rate is reasonably achievable by the company.

Alternatively if you prefer to value stocks using multiples like the price to earnings multiple. Compare the current ratio to the trailing average. If a stock has historically on average traded for a P/E multiple of 20 and today its P/E ratio is 40 its pretty clear that its expensive. If the P/E ratio is 25 it may still look somewhat expensive but not unreasonably valued. Now if the P/E ratio is 10 the stock looks pretty attractive, which begs the question why? If you can’t figure out why or you disagree with the reasoning it may be a unique opportunity to initiate or add to your position. Keep in mind that most great companies will seldom be attractively valued barring the entire economy being in a recession.

When the stock market is in the midst of a bull run, most companies will look expensive. Inversely when the economy is in a recession most companies will look cheap. The problem is that if you wait to invest only during recessions you’re going to miss out on a lot of potential returns.

In the end I would say to keep valuations simple, don’t be afraid to pay a premium for great businesses and accept that you’re going to be wrong pretty often. The true gauge of whether you are right or wrong will be measured years into the future, and I bet in-between some of your decisions will look absolutely horrible or terrific only to flip in the long run.

Recap

To quickly recap these 3 points. Use a screening tool to find companies that are already great. Spend a few minutes learning about these businesses to figure out if you really like them and if you can gauge their future outlook. Use a simple method to figure out if you think the stock is reasonably priced. If you spend the half hour or so to do this for each stock before you invest, you’ll be doing more research than 90% of retail investors. And you may find that in due time you will like the returns you see from your portfolio.

Tune out the noise, invest on your own terms and evaluate your success over longer stretches of time.

Have a wonderful rest of your Thursday!