It’s one of the most intriguing questions when contemplating long-term portfolio planning: What role should finance stocks play when you’re planning to buy things that you intend to hold for 10+ years? On one hand, the demand for things like asset collecting (mutual funds, ETFs, etc.), short-term credit (credit cards), and longer-term lending (bank stocks) is an area that will have perpetual demand. There will always be people directing other people’s investments, there will always be people borrowing money on credit, and there will always be people needing long-term loans to start a business, continue funding a business, buy a home, or whatever requires an infusion of meaningful capital.
On the other hand, financial firms carry a management risk—you can easily overleverage yourself to improve near term results, while setting yourself up for total implosion in the event that an extended economic downturn shows up. If you’re selling cookies and crackers, it’s hard to mess the business up. When the amount of liquidity and capital is inherent in your business model, the perils of short-sighted management carry extra-destructive effects.
This evening, I want to discuss how I would broadly address these colliding forces when thinking about building a fifty-stock portfolio that aims for an annual turnover rate as close to 0% as possible. But first, the usual qualifier: You should always make investment decisions within the boundaries of companies that you personally understand. It’s entirely unnecessary to do anything beyond that. In a $13 trillion American economy, you only have to carve out your little slice.
Take, for example, an excellent company I hardly ever mention: Lockheed Martin. If you had ever made a sizable investment in this stock—and preferably held for a very long time, it would have changed your life. Let’s say you bought $1,000 worth of the stock in 1977, 1978, 1979, and 1980, and intended to collect the dividends to spend however you wish shortly thereafter. If you were the typical American, this meant setting aside about a month of your pre-tax annual salary each of the four years to buy Lockheed. The attitude would be this: I’m going to use part of my income for four years to save my butt off, and then I’m going to use the next four decades to collect 160+ dividend payments from the firm as the defense business grows.
We are talking 5,037 shares of Lockheed, without dividend reinvestment. We are talking $7,555 quarterly dividend checks. We are talking over $30,000 in annual income, or roughly 7x the original investment amount. You can see why small business owners that generate $10,000+ above their living expenses each year, and use the remainder to invest, end up creating decamillion-dollar estates over the course of their life without much self-deprival outside of the early years. It’s the nature of compounding when you plant investment trees like this two or three dozen times in your life. Keep in that mind if finance stock investing isn’t your thing—you could be a random dude that bought Lockheed Martin, a stock rarely mentioned in dividend circles, and you’d be living a financially secure life off the dividend income if you’d been a long-term holder. The options to create wealth are boundless.
That said, here’s how I’d approach finance stock investing in a portfolio that consists of dozens of stocks:
I’d want to own two excellent mutual fund firms: In my case, I’d choose Benjamin Franklin and T. Rowe Price.
I’d want to own two excellent credit card companies: In my case, I would choose Visa and Mastercard.
And I’d want to choose 2-3 super high-quality banks: In my case, I’d choose U.S. Bancorp, J.P. Morgan, and Wells Fargo.
(Side note: I’d also choose two insurers that could internally compound capital well—namely, Berkshire Hathaway and Markel, but neither currently pay a dividend, and may be outside the scope of interest for those of you who come here for the site’s namesake premise).
Franklin Resources has been growing its profits 17% annually over the past decade. It made almost a billion dollars in profit in 2009, a time during which many financial firms were collapsing, requiring bailouts, and/or diluting shareholders. The dividend has been growing at a rate of 14.5% annually over the past ten years, and the dividend currently only amounts to 10% of the company’s overall profits. Franklin Resources is one of those life-changing companies for people that know about it; since 1984, it has compounded at a rate of 28% annually. That’s better than Altria. Heck, that’s better than Buffett at Berkshire. Do you realize what that kind of sustained compounding engine does to one’s financial picture? It turns $10,000 in 1984 capital into a little over $18,000,000 today.
It’s what Charlie Munger alluded to when he talked about companies that permit you to sit on your rear and collect the dividends as they come, knowing you’ve entrusted your hard-earned money to a place that will continue to work super hard on your behalf. It’s one of those companies where you secretly open up an obscure IRA, buy a few thousand dollars worth of Franklin Resources stock, click automatically reinvest the dividends, and completely forget about it for twenty years, allowing it to escape to the back recesses of your mind until one day you check the account and go, “Holy crap! I’m loaded!” It’s got a 19.3% return on total capital; it’s one of those investments you make and then leave well alone—meddling with it by selling will only cause you to later reach for the Tums when you pull out the calculator and measure what could have been.
T. Rowe Price is another investment cut from the same cloth. It has no debt at all on its balance sheet, and currently earns 21.3% on total capital. They, too, are on that small list of companies of where a modest investment held for a good chunk of time could be life-changing. Only $5,000 worth of T. Rowe Price stock, purchased twenty years ago, would be $134,000 today. It would have taken you $39,000 and twenty years to become a T. Rowe Price millionaire. Such an excellent, rarely discussed company.
The other two, Visa and Mastercard, you have heard me discuss ad nauseam. Particularly Visa. That’s because the margin of safety offered by the stock has steadily increased. Year-to-date, the price has declined 2.7%. In January, it was making $7.59 per share. Now, the price is 2.7% lower and it is making $8.80 per share in profits (while boasting a pristine, debtless balance sheet). When you buy now, you get 15.94% more earnings for a 2.7% lower price compared to January. That’s why it’s been the darling stock of this website—the earnings keep growing, but the price of the stock is not keeping pace with it. The P/E ratio is only 24x profits, which is low for a company of its growth caliber. Heck, there are retirees out there buying utilities that grow 5-6% per year at a valuation rate of 20x earnings. They get a higher dividend yield right now, and might feel good about that, but they are forfeiting so much future growth that the total wealth differentials will become enormous over time when you measure the opportunity costs. On the other hand, if 4% dividends give you more money that you need to spend per year, no need to get mad at life. You’ve won.
As for Wells Fargo, JP Morgan, and U.S. Bancorp—they are all trading at about fair value and their payout ratios have normalized (compared to something like Bank of America and Citigroup, which will give shareholders sharper dividend hikes in the coming years to catch the dividend up to what it ought to be as a percentage of profits). I’m not sure why someone would prefer U.S. Bancorp to things like Procter & Gamble and Unilever—you get the same future growth prospects and similar valuations, and yet you are able to eliminate financials risk entirely. If Wells Fargo were at $35 per share, I’d understand the appeal of loading up on it a lot more.
It seems to me that Franklin Resources and T. Rowe Price, as well as Visa and Mastercard, offer such superior growth rates (with profit levels that held up well during the recession) that they merit a place in a well-rounded long-term portfolio. Their business models aren’t susceptible to blow-up the way traditional banks are, and given their abilities to navigate the recent financial crisis successfully, they seem well positioned to handle future crises as well because they carry low debt and have vast economies of scale. The high-quality banks don’t offer the discounts that they did in past years, and seems that delaying their addition to the portfolio at this point seems wise—given that you can build a portfolio of companies with similar growth characteristics outside the finance sector entirely.