This mail bag question has to do with index investing compared to investing in individual stocks when building a portfolio.
Hey Joshua, have enjoyed reading many of your posts for a while. You articles on about.com on the mysterious world of bond investing are some of the most lucid I have read — cleared a lot of things up for me.
I read with interest a post linked today (Jan 10th, 2013) on the Wall Street Journal website, calling into question the entire “active trading” or “individual stock trading” approach advocated by many people, yourself included.
The post talks about Fortune Magazine’s “10 stocks to last a decade” — the sort of blue chip companies that you should just invest in and forget about. On that list were Nokia, Nortel, Enron, Oracle, Univision, Morgan Stanley etc. Of those 10 companies, half don’t exist any more, the others’ stock is decimated. If one had held the index, one would have been safer.
Do you not subscribe to this view? I’ve seen you talk about your brother and relative (flight attendant)’s retirement being secure since they have planted the seed of a nest egg in the blue chips, such as Apple. But who knows, Apple’s stock price could go the way of Nokia and Oracle and other seemingly infallible companies, wiping out the nest egg.
Perhaps Markowitz and Sharpe (and Fama et al.) were right when in the capital asset pricing model and its derivatives they said you can’t beat the market (or it is too risky to try to do so).
Would love to hear what you think, and how in your mind have you reconciled these two schools of thought.
A quick side note: I have never bought shares of Apple for any of my family members. You are thinking of a friend of mine I once mentioned on the site.
That aside, before I get to the heart of your question, let me wax philosophical for a few moments.
Articles like the one you mentioned go back to the granddaddy of them all, the infamous Everybody Ought to Be Rich: An Interview with John J. Raskob by Samuel Crowther, published in the Ladies Home Journal, August 1929 edition. In it, readers were urged to invest $15 per month (around $190 today) into stocks so that they, too, could someday have great wealth. Unfortunately, the article forgot to mention that the price you pay matters – your return is going to depend on your base earnings yield, adjusted for growth, and be influenced by the total rate of inflation and taxation.
By way of example, you cannot pay $100 per share for a company earning $1 per share and expect to do well unless growth is at least 20% per year for a decade; an extremely difficult feat to accomplish. Stocks, or any other asset class for that matter, are not a magical lottery ticket that will always do well for you. Many Americans just learned this lesson in a very painful way when it came to real estate (although in the case of real estate, it is the ratio of monthly home payments to median monthly income for the given market area, adjusted for supply and demand, that matters, whereas with a stock or bond, it is the cash flows from the asset that drive the valuation).
The article was great as a lesson on compounding, but terrible for what it omitted. In truth, had someone continued with the plan for the 50 years following the Great Depression, they would have grown very rich. No one ever says that, though. People point out the fact that shortly after beginning the program, stocks fell. That’s actually good for a long-term buyer.
Addressing the article you cite, in particular: In almost every case of an essay like the one you mentioned – which are designed to get people to pick up the publication with the catchy headlines – the list of stocks given are nothing more than a list of popular stocks that everyone is talking about at the time. Not one of those stocks you mentioned has ever been in any of my portfolios, nor any of the portfolios I’ve handled for friends and family. The decade before that, I remember reading about all of the dot-coms everyone “had” to own. None of them made their way into my portfolios, then, either, even though I was just a kid with a lot less money.
Why? Because I can’t predict the cash flows. I have absolutely no idea what Oracle will be earning ten years from now. None. If I can’t answer that question, I can’t value it. Anything I do is speculation, which is fine – there is nothing wrong with speculation if you can afford it – but to call it “long-term investing” is a joke. There might be people who can value Oracle. I’m not one of them. On the other hand, valuing Walmart or Amazon.com is much easier. Looking at a firm like PepsiCo compared to those two is even simpler.
If I were to put together a list of stocks that would “last a decade”, it would have to pass a series of draconian checklists:
- Does the company generate a majority of its revenues and profits from an activity that is simple to understand, has easy to calculate cost inputs, and a demand equation that is unlikely to change in the foreseeable future?
- Are there any competitors that have a greater than small likelihood of significantly disrupting the existing market share allocation among established competitors?
- Are there any unique regulatory issues that are likely to cause after-tax net margins to change, either positively or negatively?
- Is there any significant chance of equity dilution?
- Is the balance sheet strong with little relative debt and a lot of cash and / or cash generation?
- Are the products and services protected by strong barriers to entry, patents, trademarks, or other significant safeguards?
- Is the company so boring that few people will ever be attracted to it?
- Do the after-tax net earnings of the business consistently exceed the total maintenance capital expenditures required to keep unit volume steady? If the answer is “no”, the business is really a Ponzi-scheme of sorts, paying dividends to equity holders, which are funded by new bond issuances raised from the debt markets, with profits going to maintain inflation and not much more. That doesn’t interest me.
As we discussed yesterday, the companies that would make this list would be firms like General Mills, Clorox, Colgate-Palmolive, Nestle, Procter & Gamble, or Coca-Cola. Next would come starting valuation. As I pointed out many times in the past, a great business is not necessarily a great stock at any given time.
Short of some drastic market upset, it’s easy to get a general idea of what each of those companies will look like a decade from now. I have no idea what Apple will look like a decade from now. None. It could be lucrative. Or not. It could be the largest company in the world. Or not. Clorox hasn’t changed in a century. The iPhone changes every year.
These types of businesses tend to cluster around certain markets. The food industry is relatively stable thanks to trademarks – if you want an Oreo, no one else can sell you an Oreo except the firm who has ownership of the name and ingredient list. The restaurant industry is not. The banking industry doesn’t qualify because you are dealing with a lot of debt and relatively small amounts of equity. Consumer staples fit perfectly but consumer durables don’t. Then there are specific companies that have unique advantages – Compass Minerals of Kansas City, for example, is one of only a tiny handful of businesses in the world that provide salt to highways to de-ice following winter weather. That’s not a business that is likely to change much in the next ten years. There aren’t many competitors. If the price is right, it’s not that hard to figure out whether you will make money or not.
Addressing Your Broader Question About Using an Index Strategy vs. Individual Stock Selection
Whenever someone says that a particular portfolio did, or did not, beat a particular index, it always amuses me. Logically, what they are saying is, “This basket of stocks did not perform like that basket of stocks.” Of course it didn’t. They are not made up of the same assets, at the same time, at the same price points.
Imagine that I woke up at 25 years old, with no debt, and a suitcase full of $100,000 in cash. I was given a choice between putting it in the Dow Jones Industrial Average or investing it myself.
First, you have to understand that there is no such thing as the Dow Jones Industrial Average. There is an imaginary list of companies chosen by the editors of The Wall Street Journal. Were I to buy an index fund that matched the Dow, my portfolio would consist of the following holdings:
- $11,000 worth of IBM
- $6,300 worth of Chevron
- $5,520 worth of 3M
- $5,420 worth of Caterpillar
- $5,210 worth of McDonald’s
- $5,080 worth of Exxon Mobil
- $4,840 worth of United Technologies
- $4,390 worth of Boeing
- $4,240 worth of Travelers
- $4,120 worth of Johnson & Johnson
- $3,950 worth of Procter & Gamble
- $3,900 worth of Wal-Mart Stores
- $3,630 worth of Home Depot
- $3,470 worth of American Express
- $3,030 worth of UnitedHealth Group
- $2,900 worth of Disney
- $2,630 worth of DuPont
- $2,630 worth of JP Morgan Chase
- $2,480 worth of Verizon
- $2,440 worth of Merck
- $2,110 worth of Coca-Cola
- $1,960 worth of AT&T
- $1,530 worth of Pfizer
- $1,510 worth of Microsoft
- $1,240 worth of Intel
- $1,210 worth of General Electric
- $1,170 worth of Cisco Systems
- $930 worth of Hewlett Packard
- $670 worth of Bank of America
- $510 worth of Alcoa
When you say, “Why wouldn’t you want to own the index?” what you are asking me is, “Why wouldn’t you want you assets allocated exactly like this?”. To repeat: There is no index. It’s a fictional idea to help rationalize the concept of equity ownership in a way people can perceive more easily.
Looking at that list, there are certain types of companies that perform better over long periods of time, provided the price is rational, than other types of companies. I am not, for example, interested in owning Alcoa at any price, unless I am speculating with it as a short-term trade due to cyclical factors. That is not a firm I am going to buy and hold. The returns on equity are not high enough to offset the necessary capital investment and you cannot get a decent increase in real, inflation-adjusted earning power over time.
On the other hand, I’d love to own Johnson & Johnson because it generates real, inflation-adjusted increases in wealth. Whether I wanted it added to my portfolio would depend on whether the base earnings yield, normalized for one-time events and tax law, at least exceeded that available on the 30-year Treasury.
Likewise, why would I want to own $5.21 worth of IBM for every $1.00 I owned worth of Coca-Cola? Both are good businesses but I do not find IBM 5.21x cheaper or more attractive than Coke at present levels. That seems like an irrational allocation decision; the numbers do not warrant it. The only reason it is this way is because the Dow weights stocks based on share price, which is entirely arbitrary! IBM is now $192.88 per share and Coca-Cola is $36.96 per share due to Coke’s stock split last year.
For me, given my ability to understand advanced accounting, and my joy of owning specific businesses, I would be happier if I were to split the $100,000 into no fewer than 20 piles of $5,000 a piece and no more than 50 piles of $2,000 a piece (depending on how cheap stocks were in general at the time), allocating the money to businesses that were not likely to change, that had long histories of making a lot of money for owners, and that returned a significant portion of cash in the form of dividends. Those dividends would serve as a counterbalance during bear markets, as well as provide fresh capital to reinvest to take advantage of the lower prices, assuming I wasn’t allowed to add additional outside money to the portfolio.
For Most People, Indexing Is Still the Best Strategy
This may sound like an odd statement given what I just said, but for many people, especially those with small amounts of money and simple needs, indexing is the superior strategy. If something were to happen to me, I would want my extended family to put everything into a low-cost index fund at Vanguard, reinvest or live off the dividends, and ignore it for long periods of time. I wouldn’t want them selecting individual equities.* [See Update in Footnotes] That’s because the list of stocks in the Dow Jones, overall, is very good. It is. For someone who can’t value a business, owning that basket makes a lot of sense. (With the portfolio I own now, they wouldn’t have to make the switch right away. The stocks held in our accounts are among the most stable, blue chip firms in the world, bought at attractive prices over the past few years. The portfolio should continue to run itself with no turnover for the next decade.)
While we are on the subject, consider this paradox: If a significant majority of investors began to index, indexing would no longer work for a lot of structural reasons as the underlying equity market would break down and become non-functional. It’s also interesting that indexes are far less diversified than people like to think. The Dow Jones Industrial Average contains 30 stocks, but 56% of the assets are held in the top 10 of those stocks.
I sleep well at night 1.) knowing what I own, 2.) knowing why I own it, 3.) being able to compare the yearly performance of the underlying business to the expectations built into my valuation model to determine how accurately I discounted the cash flows and thus, calculated intrinsic value, 4.) being tied to specific businesses in the same way I love the private companies I own. I love the fact that when I walk into a movie theater, it is almost impossible for me to get from the ticket booth to the seat without encountering at least four companies that are paying me cash dividends every year. I’m just as much an owner, and feel that way, for those firms as I am the ones under my control. I know their sales, their profit margins, their returns on capital, who is running the management team, and the price I paid for my stake.
If I had to buy a basket of stocks chosen for me by the newspaper editors, it would be boring. I certainly wouldn’t be writing and this blog would never discuss finance. I love understanding working systems and economic models. Businesses let me do that while increasing my purchasing power. I find it enjoyable, and I’m good at it. Why change?
For more information, you may want to read this mail bag question from the past.
*Update December 10th, 2015: This will no longer be the case, effective sometime in the first half of 2016, because we are launching a global asset management business specializing in value investing for affluent and high net worth individuals, families, and institutions who have $500,000 or more in investable assets. Over time, I expect to transform it into one of, if not the, central capital allocation hub(s) in our lives; a firm through which multiple generations of the Kennon and Green family tree have their finances managed and investments overseen with an emphasis on long-term ownership, low turnover, tax efficiency, and risk management.