All of my articles, summed up into one:
#1. If you want to own companies that you can hold for three decades without thinking about hardly at all, then you have to avoid banks and the tech sectors entirely. Things like Wells Fargo and IBM will probably do very well over that time frame, but they require the steady guidance of montoring—the amount of debt a bad management team could put on a bank’s balance sheet quietly or the quickness of technological change over a short period of time make these stocks ineligible for permanent capital categories. If you want to think about “forever” investing, you need to focus on food, beverages, and the diversified energy and healthcare companies.
#2. When tempted to make a concentrated bet, remember why you entered investing in the first place. Although there are many reasons why people don’t like relying solely on the income they receive from their job to live off, one of them is this: they don’t like the fact that at the word of their employer, all of their income could dry up instantly.
When you invest, the same logic should apply: you don’t want a substantial chunk of your income to dry up simply because one Board of Directors said so. What’s the old John David Rockefeller line? Something like “I’d rather have 100 people owe me $1 than have 1 person owe me $100.” There are 15,000 companies out there in which you can purchase ownership stakes. There is no reason to limit it to one or two. You ought to be able to pick a few dozen that get the job done.
Someone who had 20% of their portfolio in BP because they (correctly) thought it was an awesome company would have had a rough go of it in 2010 after the oil spill in which the $0.84 dividend cut was suspended, then cut in half, and is still recovering to its pre-oil spill highs. On the other hand, an investor that said, “I want 20% of my wealth in energy assets” is going to have a pretty sweet life by dividing that 20% portfolio into six chunks consisting of ExxonMobil, Chevron, ConocoPhillips, BP, Royal Dutch Shell, and Total SA. The growth profile of BP alone isn’t better than this six-stock combined entity, and yet the benefits of spreading your bets across those six iconic oil firms is significant compared to a concentration in just one of them. Plus, it’s just more fun to collect $10,000 in total dividend income that is split into twenty-four pieces of roughly $416 rather than four checks of $2,500. But maybe that is just me.
#3. Apply my favorite filter to stocks, which is this: Look for companies that have been raising their dividends for 25 years, and have been growing profits by an average rate of above 5% over the past decade. It’s the best formulaic way to screen for stocks that I know, because it does two things very well. First, the twenty-year dividend streak ensures that the company has a durable business model that will be around for a while, which makes the inevitable 25% and 50% drops much easier to handle when you know the company is going to survive.
The insistence on a 5% growth rate helps to make sure that you are increasing your wealth at a rate greater than inflation, and you’re not dealing with a moribund dividend growth company (there are a few dividend growth companies that limp along with 1% and 2% dividend increases, but do not actually make you richer). When you combine lengthy histories with satisfactory business performance over the most recent full business cycle, you are treading on fertile soil for super long-term investments. A portfolio consisting entirely of these types of securities (a la Emerson Electric, 3M, Procter & Gamble, Colgate-Palmolive, and Coca-Cola) is the closest you will come to long-term guarantees in the financial world.
#4. Never pay more than 30x earnings for a large non-cyclical company. The only time I’ve ever seen paying exorbitantly for a big company work out is Starbucks, in which case investors that paid 50x earnings a generation ago still reaped 20% annual returns. But those situations are very, very rare. Since 1998, Coca-Cola investors have only received annual returns of 2.78%, even though the business grew by almost 9% over that time frame. People were doing crazy things like paying 50x earnings for the company, almost ensuring mediocrity.
When companies like Coca-Cola and Colgate-Palmolive start to drift from 20x earnings to 30x earnings in their valuations, you start sacrificing your future turns a bit. Paying 25x earnings for Coca-Cola won’t be the end of the world; you might get 7.5% annual returns instead of 8.75% annual returns. In other words, you receive less returns than would be fully justified by the growth of the company, but the wealth creation process still continues undisturbed (it is when you cross the 30x earnings mark for a mature American companies that you actually begin impeding the wealth creation process).
#5. Reinvested dividends are a great way to build a wealth torrent that marches forward. I write about this stuff all the time, and it still amazes me what compounding can do when you give it over ten years or so. In the past generation, AT&T has paid out over $32 in total dividends, with an average reinvestment price of nearly $16 per share. Loosely speaking, AT&T has turned every 1 share owned into 3 shares owned over the past twenty years, due to the power of dividend reinvestment.
That’s huge. When you evaluate the 1998-2014 period for AT&T, you might see a dividend that has grown from $0.94 per share to $1.84 per share. Someone just looking at that might think, “Okay, your dividend doubled, that’s nice.” But that is only a partial story. Someone with 1,000 shares didn’t just go from collecting $940 annual dividends to $1,840 annual dividends. No, they also saw their share count in the telecommunications bellwether increase from 1,000 shares to 3,000 shares. Really, the $940 income grew into 3,000 shares paying out $1.84 so that you’d actually be collecting $5,520 annual checks from AT&T rather than the $1,840 you might think. This is life-changing stuff if you recognize it and harness it.
If you follow these five rules, there is a very, very high probability that you will create a portfolio that can last for the long-term, and be able to weather things like 2008-2009 financial crisis, the 1973-1974 bear market, and even something that comes within hailing distance of another Depression.
Originally posted 2014-12-10 08:00:55.