Pay Attention to the Weightings of Your Individual Holdings When Constructing a Portfolio

One of the things that worries me from a risk management perspective is investors who don’t know what they own or their actual, real portfolio weightings. Sometimes, I’ll hear new investors say, “I own stocks” or “I own mutual funds” but neither is an answer. Those aren’t the relevant details. The real question: “In which enterprises, on what terms, and at what price has the money been invested, laid out, and exchanged?”. Much of everything else is a smokescreen serving to obfuscate reality. It’s risk-adjusted reward we’re after; reward measured in after-tax, net-of-inflation real purchasing power.

To explain what I mean, let me take a round-about journey, re-visiting some ground we’ve discussed in the past. This will let me frame the discussion in a way that should clarify the underlying point so that it emerges organically.

Let’s imagine you have $100,000 in a portfolio. You call this portfolio “The Blue Portfolio”. It is divided into four companies (in reality, you’d have many more as it would almost never be prudent to have all of your wealth divided solely into four companies absent an extraordinarily good reason but let’s keep it simple for the sake of efficiency as the concept is what is important).

25% into Company A, a sporting goods business
25% into Company B, a software business
25% into Company C, a coffee business
25% into Company D, an oil company

At the end of the year, the portfolio has increased in value by 11%, to $111,000. The weightings of your holdings are as follows:

Company A has grown to $32,000
Company B has declined to $21,000
Company C has grown to $41,000
Company D has declined to $17,000

Of course, as most of you know, from both an academic and pragmatic vantage point, it is nonsensical to measure your equity returns over periods of twelve months. At the very minimum, a holding period of five years is required to begin to reduce price fluctuations and let intrinsic value exert its gravity-like force on the mercurial market price. You’d behave this way when looking at an apartment building, the copyright to a novel, a royalty stream from mineral rights, or a private business so partial ownership of public enterprises should be no different. In fact, when you’re dealing with certain businesses such as the oil majors, you need measurement periods that are much longer than that because you, as an owner, are being paid to absorb volatility, typically receiving above-average market returns over decades in exchange for multi-year periods of extreme distress. As long as the underlying components in The Blue Portfolio are fine, the key to success for most investors is going to be passivity; regularly buying and holding, perhaps reinvesting dividends, keeping costs low, and letting time work its magic.

Of the three primary ways most investors put money to work – systematic accumulation, valuation-based accumulation, and market timing (the latter of which is de facto speculation and cannot be done consistently with any degree of predictability) – the mechanics may differ based on factors such as personality, cost, and convenience.

For example, if you were taking a systematic accumulation approach, you might:

Regularly contribute a fixed amount of money and divide it equally among the components of The Blue Portfolio; e.g., you deposit $400 a month and invest $100 each into shares of Companies A, B, C, and D.
Match the existing market-weights at the time of the deposit; e.g., you deposit $400 a month into your portfolio with this month, you put $115.32 into Company A, $75.68 into Company B, $147.75 into Company C, and $61.25 into Company D to maintain the ratios that have naturally developed.

On the other hand, if you were taking the valuation approach, you would analyze each holding, calculate the net present value of the owner earnings using different probability assessments so you could build in a margin of safety, and then, after looking at your overall risk profile, make allocation decisions. You might decide that Company C has much better underlying intrinsic value than you realized while Company D is undervalued due to fear in the sector, splitting the $400 into two piles of $200 each, adding to those two components. Or, if you invest on a basket-basis, you might decide that the entire Blue Portfolio is too expensive relative to bonds and sell some off to buy fixed-income securities.

We’ll skip the market timing approach. It’s neither relevant nor advisable.

When you understand that this is what is really going on with equity portfolio construction – it’s all just individual stocks with the specific weightings determined by the methodology the investor has selected, whether it be outsourcing the rules to a committee, as in the case of an S&P 500 index fund, picking up an equally-weighted ETF focusing on a single sector as part of a diversified portfolio, or hand-building each component in the old-fashion, Benjamin Graham school, insofar as risk can be managed, everything, in the final analysis, comes down to 1.) which companies you own, 2.) the proportion in which you own them, 3.) the combination of earnings growth and dividend yield of those holdings (the drivers of total return from an operational perspective), and 4.) the valuation multiple applied by other investors. That’s it. Everything else is a distraction or merely ancillary to the core reality unless you’re dealing with some sort of esoteric strategy that is wildly inappropriate for most people, such as converting volatility into an asset class of its own and profiting from the willingness to absorb risks for third-parties (e.g., writing cash secured equity puts with surplus funds or selling covered calls against holdings you already have on your books).

When You Think In Terms of Underlying Holdings, You Realize How Mathematically Bizarre or Misguided a Lot of Statements Can Be from a Portfolio Weighting Perspective

It’s a concept that every investor should internalize because it makes it much more difficult to lose your minds with crowds as you are forced to focus on the underlying foundation; what you really own; the engine that is generating wealth for you. It reframes everything in your mind so you see the actual, net effect, both in risk exposures and potential rewards, of suggested changes to your assets.

Let me give you an illustration. Recently, there was an article published at BloombergGadfly called Exxon Is the Coldplay of Oil Stocks. It contained this passage:

Yes, Exxon’s total return last year, including its sacrosanct dividend, of negative 12.8 percent was much better than the SPDR E&P ETF’s negative 35.8 percent. Yet Exxon still lagged behind the S&P 500’s total return of a positive 1.4 percent.

So if it is scale, diversity, and dividends that you value and you think energy is due another bad year, then why not just own the market rather than Exxon?

Immediately, you should recognize the question, as presented, doesn’t make any sense. What is the actual question? Let’s say that you use the largest domestic definition of “the market” and search for one of the best ways to accumulate it at the lowest cost. Assuming you’re investing through a tax shelter, one of my favorites for the task would be something like VTSMX, which is the Vanguard Total Stock Market Index fund so we’ll go with that (if you have an objection, insert your own favored fund here). The methodology employed, subject to some of the same caveats we discussed pertaining to the S&P 500 equivalent, means that the real inquiry being posed is, “Why buy shares of Exxon with this pile of money? Instead, you should put 3.01% of your cash in Apple, 1.95% in Google, 1.75% in Microsoft, 1.52% in Exxon, 1.26% in General Electric, 1.25% in Johnson & Johnson, 1.14% in Wells Fargo, 1.11% in Amazon, 1.10% in Berkshire Hathaway, 1.10% in JPMorgan Chase, 1.00% in Facebook,” and on and on it goes.

It other words, you can quite literally rephrase the question as “Why not just [put 1.52% of this new deposit into Exxon] instead of [an undisclosed percentage that has not been, and will not be, discussed at any point in the article] Exxon?”, cutting right to the heart of the matter. Mathematically, that is what is happening; the nuts and bolts of the figures no matter what kind of language is used to describe it. I walked you through a similar example in much more detail in a post called What Do You Think of Rod’s Investment System?, which breaks down the fallacy that “the market” exists. You can’t buy the market because there is no such thing as the market. There are only individual stocks, at specific weightings, with specific rules. The key to success, at the risk of repeating myself: You want reasonable costs, good tax efficiency, long holding periods that favor passivity over frequent trading and activity (along with all the costs that such behavior generates in not only commissions but ask/bid spreads), and acceptable levels of diversification. How you do that is less important as long as you do it. It’s going to differ for everyone based upon their own opportunity costs.

To be blunt about it, if you hear someone say, “Why do you own [insert shares of company here] when they were [insert performance here] when you could just own the index, instead?”, realize that it is a mathematically ridiculous question. For someone to state it indicates they truly have not internalized the math and structure of how the whole system works. The odds are good the index itself owned that particular security for heaven’s sake. The only relevant consideration is how the entire portfolio performed, which is influenced by the portfolio weight you’ve assigned to that component. Stated another way, the question is as nonsensical as calling Fidelity or Schwab, Vanguard or T. Rowe Price and demanding to know why the S&P 500 index fund invested in shares of Apple when it could have invested in the S&P 500, instead. Anyone who is familiar with the mechanics is likely to bang their head on the table. It makes no sense. None. It’s not how it works. Peter Lynch at Fidelity used to write about how this weird focus on individual components rather than their relative contribution to the total return of the portfolio led to all sorts of bad incentives and behavior on the part of portfolio managers who gave into the pressure to please these arithmetic dumb dumbs. Investors, in other words, get what they deserve in a lot of cases; how the asset management industry had been effectively incentivized into doing what was most rational for the employees rather than the investors because the investors didn’t know what they were doing. To paraphrase his comments on it, you had portfolio managers who “bought IBM because if it declines this quarter, the question is ‘What the hell is wrong with IBM?’ rather than shares of this really promising, reasonably valued restaurant because if it doesn’t do well, the question will be ‘What the hell is wrong with you?‘ They’d like to keep their job.”. A related practice is known as “window dressing”. It’s crazy but it really happens.

(Side note illustration: If you’re working for an employer offering a limited menu of 401(k) plan options, the optimal choice is almost always going to be a cheap well-run index or value-based fund purchased up to the point of receiving the free matching money. I recently had someone ask me to allocate their 401(k) account after reviewing the choices, the most intelligent thing on the table given their age, risk profile, and current asset allocation outside of the retirement plan was a 67% weighting to the Vanguard Equity-Income Fund and a 33% weighting to a stable value fund paying 1.20% per annum. That wouldn’t have been my first choice if this were a custody account in which I could make any allocation decision I wanted but it was, in my opinion, the best choice all things considered under the set of circumstances this person found themselves. If the long-term managers changed, or I began to not like the valuation and weightings of the underlying portfolio, I’d make a phone call but for now, it was the closest thing to the risk/reward/cost sweet spot on the roster his/her employer provided.)

The point is, looking at an individual component that is part of a diversified portfolio and comparing the component in any given year to the portfolio itself is not an intelligent way to analyze the situation outside of desegregating the measurement period’s total return because it doesn’t get to the core issue: You’re talking about absolute and relative weightings. If someone says, “I’m thinking about adding shares of Exxon to my portfolio”, it’s a nonsensical response to say, “Why not buy the index, instead” because you don’t know the weighting the person is considering. That is vital information that has been left out of the discussion. Rather, the more accurate questions are, “Why do you want to weight Exxon differently than 1.52% of your assets? What weighting are you considering? Is this worth the cost and effort relative to the rewards?”. You’re getting Exxon in both cases. It’s a matter of how much gets stuffed into the basket that is working for you and your family.

One reason you might want to buy Exxon outright is the practice of tilting your underlying weightings toward assets that have a better risk/reward trade-off, such as increasing diversification or taking advantage of valuation differentials from time-to-time. Imagine you are a 50 year old office worker with $200,000 in your portfolio, all of which is in an S&P 500 index fund; the sole low-cost index option offered by your employer. It can be perfectly reasonable to say, “I don’t have any international stocks so I’m going to open a brokerage account and buy $4,000 worth of Diageo shares and $4,000 worth of Nestle shares with extra money I save over the coming 18 months.” Why? The Diageo and Nestle, both of which are among the best 100 companies in the world in terms of long-term safety and earnings power, are part of a broadly diversified portfolio. You shouldn’t look at them and say, “Oh, [good/bad] they [beat/underperformed] the market this year.” You shouldn’t look at them and say, “I own two individual stocks”. Instead, you should look at them and say, “I introduced two more components in my overall weighting and these are analyzed as part of the S&P 500 index fund I hold in my 401(k).” Desegregate your index funds, break apart your ETFs, and combine the underlying investments with the two individual stocks you own to get a better view of your holdings. The fact that most of your assets are held indirectly doesn’t change reality. The portfolio composition is what matters. They are part of a larger picture.

Morningstar, the mutual fund research giant, has an incredibly cool tool for professional subscribers designed specifically for this purpose. They call it “Instant X-Ray”. You enter the index funds, mutual funds, ETFs, or comparable publicly-traded pooled investments you own, along with any individual stocks, and it produces a report to show you your actual overall portfolio weightings. You can then compare it to a benchmark if you’d like, to see how differently you’ve allocated your assets than your preferred yardstick. This way, you can spot many of your relative risks a lot easier. You can also see how your portfolio looks as a single stock compared to a benchmark (e.g., the p/e ratio, weighted ROA, weighted ROE, projected EPS growth, dividend yield, etc.) It’s particularly useful for uncovering concentrated positions or certain correlated dangers you didn’t realize you had on your books. For example, if you own a dozen mutual funds and index funds but several of them put a big chunk of their holdings in a single firm, you might not realize you’ve hitched your economic wagon heavily to shares of one business; far more than you’d be comfortable with if you held the stocks individually. This tends to be a particular danger during periods of “irrational exuberance”, to borrow a phrase from the former Chairman of the Federal Reserve. If you doubt it, go back to the disclosures of the late 1990’s and start looking at how much capital was concentrated in the top, wildly overvalued technology firms among different mutual funds and index funds. Folks weren’t as diversified as they thought.

Examples of How I Focus on Portfolio Weightings In My Own Life

Why am I telling you this? Simple. No matter how you construct your portfolio – traditional index funds, low-cost ETFs, individual securities held in a custody account – I want you to occasionally ask yourself, “What do I actually own? What are the risks of my underlying holdings?” When you add or subtract an asset from your balance sheet, I want you to take time to inquire, “How does this change my overall risk/reward profile?” Portfolio construction is a skill set that is different, and no less important, than asset selection. It’s not just about finding assets you like. It’s about building a portfolio that achieves your unique goals and objections within risk parameters you can accept.

Here are two real-world manifestations in my own family’s situation:

1. Last week, I was answering a question about the only place in which I use index funds – The Kennon-Green Foundation. In my reply, I said:

“The closest a retail investor could come to replicating the weightings of the individual underlying components held in my family’s charitable foundation by using a mainstream asset management company would be a roughly even split between something like FSTMX or VTSAX, on one hand, and something like EFA or FSIVX on the other. (You could not opt for VTIAX to replace the latter because I purposely avoided direct ownership of many Chinese securities – I want a lot more wonderful businesses like Nestle and Novartis in Switzerland rather than technology conglomerates in Hong Kong trading at 2.5% earnings yields, which is present in the Vanguard equivalent due to a change in the underlying construction methodology. This is because I consider a lot of the Chinese holdings sub-par in both valuation and risk trade-offs relative to their European counterparts, influencing my decision. I’d rather get exposure to that particular market through American, British, French, German, Swiss, Japanese, and Australian blue chips but this has to do with my own preference for risk reduction whenever and wherever possible).”

Despite indexing as a strategy for the privacy reasons I’ve previously laid out on the topic (utilizing a donor-advised structure lets me avoid filing a Form 990, which would be visible to the public), I still focus on the underlying composition of the portfolio as well as the valuation of that portfolio. I didn’t want my charity’s money invested in China except to the extent it was done indirectly through multi-national corporations focused on dominating specific markets, such as Colgate-Palmolive with its toothpaste or Coca-Cola with its beverages. I don’t care about the exotic or getting some sense of excitement from my asset roster. I care about sustainable, predictable earning power relative to the price I pay for it. Many Chinese firms scared me at the time. I didn’t ignore that just because I employed index funds.

2. Despite my frequent praise for things such as VTSMX, explaining how it is often a superior choice for inexperienced investors with smaller portfolios who want to effectively automate their capital at an affordable price with an emphasis on passivity, I don’t own any in my own life because it’s nonsensical for me to pretend like my experience, skill set, and interests don’t exist. This is what I do for a living. This is what I think about when I’m going to bed at night. This is what Aaron and I talk about when we are driving somewhere. If I bought, say, a new block of $100,000 worth of VTSMX this afternoon, I’d be getting 1,820% more Facebook stock in that new holding than I am shares of something like The Hershey Company. That’s madness to me. I don’t have to pretend like I don’t know that.

It matters to my risk preferences. I have no idea what Facebook is worth. I hope the people who own it make a lot of money from it, even if it means they compound at a higher rate than my own assets. I really do wish the best for them. I don’t want to own it, though. Not at this price. I don’t feel satisfied with the probabilities; certainly not enough to put $18.20 into it for every $1.00 in Hershey I bought. A quarter-century from now, I have no idea what Facebook, the business that drives intrinsic value, will look like. I have no idea how much money it will be making. Maybe someone else does. In contrast, I am fairly certain that Hershey, at this price, has what I consider a high probability of turning every $10,000 or so into at least $135,000 over that same span on a total-return basis; much better, in my estimation, than the typical business and the S&P 500 as a whole. I understand its valuation. I understand its product mix. I understand the population growth trends. Though it won’t make you rich overnight, I consider that sort of long-term compounding rate satisfactory with a degree of safety not present in other investments. If I bought more shares of Hershey today, it wouldn’t bother me even if they were to collapse by 50% tomorrow provided the long-term economic engine is still intact because I have no plans on selling them. It wouldn’t bother me if the S&P 500 outperformed it by a 3-to-1 margin over the next 36 months. I don’t care. It is a single component in my overall portfolio, weighted much more heavily than in a comparable index fund. I know what I’m getting, I know what I believe to be the likely potential downsides. I don’t care about the individual firm volatility as the shares are fully paid for and mostly parked in cash accounts because, all else equal and absent non-foreseen events or liquidity needs, Aaron and I plan on holding them until we die, someday leaving them to our future children and grandchildren. Even if there is some sort of failure event, the portfolio construction method we use should ensure we make at least some money (the same way shareholders of Eastman Kodak did despite the bankruptcy) due in no small part to what we consider adequate diversification for our purposes. We should be happy with the outcome. To turn down the opportunity to buy it (and we did recently accumulate a lot more) is not a wise way to behave for no reason other than the fact it may not do relatively well compared to an arbitrary benchmark over the short-term.

This is because I think of myself as being in the business of accumulating profits. I want to buy the most net present value look-through earnings and assets I can whenever I write a check so that I increase the quantity of funds being generated by the economic engine I’ve been building throughout my life; an engine that has made it possible for me to enjoy total freedom over my time without ever having to go to work for someone else. Given how young I was when I started, I’ve spent roughly 23 years of my life with most waking hours buried in financial statements and regulatory disclosures. If you see me walking around Kansas City with a cup of coffee in my hands like I was a few days ago at the Country Club Plaza, it’s probably what’s on my mind. It’s fun to me. I’ve arranged my entire personal and professional life in a way that nobody can force me to sell something because it’s ugly on paper at any given moment because, long-term, more often than not, I’ve proven to myself that my judgment is better than theirs. I know what I own and what I want to own. I know what I paid for it and what I want to pay for it.

The Point of Discussing Portfolio Weighting

There are times when I’ll purposely avoid stating my own conclusions or take-away so you think about a topic on your own. I want you to ruminate on it, coming to an opinion for yourself after considering the variables you think are relevant. In this case, I’m going to be a bit more direct and come out and explain why I’m writing this.

I see a lot of new and inexperienced investors take risks they shouldn’t take. They buy index funds that offer terrible risk/reward trade-offs (e.g., I recently had someone sell a low-cost fixed-income index fund in their employer-sponsored retirement plan after the comparably low-cost advisory firm suggested she buy it because the underlying holdings were mostly made up of – I kid you not – intermediate debt instruments of emerging market sovereign governments. This was a person near retirement in the United States who had no business lending money to the governments of Latin American and Asian countries regardless of the potential return. It would have been better, given his/her unique circumstances, to park it in a 60-month FDIC insured certificate of deposit from Barclay’s for 2.25%.) They buy ETFs that have horrible structural risks (e.g., employing leverage or designed for speculation in that they reset on a daily basis, making long-term profit a mathematical impossibility for reasons they don’t understand). They decide to invest in individual stocks directly and go dump all of their money in a handful of securities they don’t understand, exposing their hard-earned capital to the chance of real losses.

Focusing on the underlying weightings lets you see where your money is actually parked and many of the risks to which you’ve exposed yourself. It can make even novice investors behave more intelligently. For example, let’s say you are 30 years old with $50,000 in your portfolio. You decide to open an account with Fidelity. Focusing on the underlying components is going to lead to better behavior. You might divide your money 37%/37%/16% into the Fidelity Spartan Total Market Index Fund (FSTMX), the Fidelity Spartan Global ex U.S. Index Fund (FSGUX), and the Fidelity Spartan U.S. Bond Index fund, then use that last 10% to augment the holdings you really like; great blue chip companies at attractive valuations that you plan on leaving to your kids so they represent a slightly higher percentage of your composition weighting; e.g., you split it into five $1,000 piles and pick up extra shares of Hershey, Johnson & Johnson, Procter & Gamble, Nestle, and Coca-Cola.

On a long-term basis, you’d have not only lowered your expense ratio (other than the initial commission, the augmented stocks should have no on-going costs) but reduced your risk by slightly tweaking your holdings toward more stable, blue chip enterprises that have survived recessions, depressions, war, inflation, deflation, and countless other variables. That’s a really good, satisfactory portfolio. The underlying holdings are, for the most part, far better than you’re going to get with many other setups. Sit on your behind for the next few decades, dollar cost average into it, and you should be okay. Had you been picking funds off a roster without any examination of the underlying holdings, you might very well have ended up with a lot of junk that you had no business owning.

A sidenote, though: If you tweak your portfolio weightings as in this example, I highly recommend you stick to what you know. Here’s what I mean: If you’re a doctor, you probably have seen the near total domination of Kimberly-Clark products in hospitals throughout the country. All day, every day, the medical community is pumping cash into stockholders’ hands. It is a silent juggernaut off the radar of most investors; a juggernaut that enjoys entrenched advantages that make it nearly impossible to unseat, explaining how the enterprise has been a money-printing machine since 1872. Those earnings make their way into shareholder hands both from long-term appreciation and dividends, driving total return. The dividend record encapsulates this nicely. Take a look at it! Every year, more and more cash shows up. How many people do you know who enjoyed a pay raise at this rate over the past couple of decades?

At the moment, I don’t consider Kimberly-Clark to be attractively valued. In fact, I think it’s slightly overvalued. However, imagine we go into a 1973-1974 style meltdown. Perhaps we experience a 1987-style collapse. These things happen every generation or two. You don’t have to mortgage your house and sell your index funds to take advantage of it. Increase your savings rate, sell off some other assets, and consider bringing it up to a 3% or 4% weighting in your diversified portfolio between the individual shares you own and the shares you hold indirectly through your index funds and mutual funds. In essence, you’re customizing your index fund at the margins without doing anything foolish. It’s okay to behave modestly. This is not Las Vegas. You do not have to put all of your money on black to get rich. Go through life making all sorts of small intelligent decisions and the cumulative effect can be substantial. You get Kimberly-Clark. I’d argue it’s in your best interest to buy it under such circumstances rather than acquiring shares in some energy trading conglomerate that is well outside of your knowledge base.

Other situations involving similar trade-offs might arise from time to time. If you get hired by a start-up and you see, with your own eyes, it is enjoying exponential growth; that the profit is real (it’s not just burning through venture capital funding), new employees are being added, pay raises are being handed out, and that new divisions are being created and expanded, deciding to take advantage of the opportunity to buy shares before the IPO in an employee-only round of equity raising very well could be a good decision. Why, in such a situation, would you run off and put your spare money in shares in other companies with which you are less familiar and that are not nearly as attractive instead of the one that is succeeding right in front of you? In the same way people drive their cars into lakes because they don’t want to question the navigation system instructions, too many people buy into this efficient market nonsense where they allow themselves to be conditioned by others, achieved through social proof and a myriad of mental models, to stop thinking; to turn down opportunities because it doesn’t fit within some orthodoxy. Don’t do it. If you’re looking, a few times in your life, you’ll see something squarely in your comfort zone – something right there, in front of you, that you understand backwards, forwards, upside down and inside out – that is clearly an intelligent thing to do. All the numbers work. You know in your heart it’s legitimate. You are familiar with the variables. If, when these ephemeral gold mines present themselves, you fail to take advantage of it, you have no one to blame but yourself. Maintain your independence of thought. (Likewise, don’t allow others to get you to invest in something that causes you discomfort or that you feel you don’t fully understand. It’s your money. Nobody gets to tell you what to do with it. You don’t have to explain yourself.)

Keep It Simple, Think Independently, and Don’t Let People Bully You Into Things You Don’t Want To Do

Always be thinking about portfolio construction and the actual, underlying assets upon which you’ve staked your future. I don’t care if you buy individual stocks. I don’t care if you prefer index funds. I don’t care if you accumulate REIT ETFs. What counts is that you get your hands on real operating assets producing real cash flows by providing real goods and services at a profit to customers; that you pay a reasonable price for that ownership, that you hold it in a tax-efficient way; that you keep your costs manageable; that you are diversified enough to withstand failure from time to time; that you sit on those assets for long enough to absorb the volatility that is part and parcel with holding securities (the old phrase, “time in the market beats timing the market” sums it up perfectly).

In other words, keep it simple and don’t fall into the “true believer” or “irrational escalation” trap where you start thinking there is only one way to financial independence. If you’re tempted to make big moves, consider that it may be more prudent to tweak at the margins like our Kimberly-Clark example. This is not some religious or political purity test where heretics will be cast into outer darkness. Do whatever makes the most sense in your personal situation as well as what provides personal utility in terms of happiness so you’re more likely to stick with the plan or increase your savings rate; e.g., buy index funds through your 401(k) at work, take advantage of DRIPs for the handful of businesses you want to own directly, pick up high-quality cash-generating real estate in your hometown. It’s not all-or-nothing. As weird as it sounds, you will run into folks that, if you deviate from their preferred system, will have an emotional tantrum. Ignore them. The important thing is your odds are greatly improved if you:

Spend less than you earn, building a surplus;
Let compounding work its magic on that surplus over long periods of time (the speed should come from expanding the core economic engine in your life, not your securities portfolio, which is really a way to inventory and expand profits);
Prefer passivity over lots of activity;
Stick to what you know and understand.

Most of the other stuff is trivial; mechanisms and means to an end. It’s all about buying cash flows. That is the steak to the sizzle. Get your hands on cash flows. Get your hands on enough that you can sit at home and the money arrives regularly so you have the freedom to determine when, how much, and under what conditions, you sell your time.

Fiduciary Wealth Management

Joshua Kennon is a co-founder and Managing Director of Kennon-Green & Co., a private asset management firm specializing in global value investing. The firm operates as a fee-only fiduciary that seeks to help affluent and high-net-worth individuals, families, and institutions protect, preserve, and grow their wealth.

This site, JoshuaKennon.com, is Mr. Kennon's long-time personal blog and is separate from Kennon-Green & Co. Nothing in this article or elsewhere on this site is intended to be, nor should it be construed as, individualized investment advice, a recommendation, or an offer to buy or sell any security. Investing involves risk and may result in substantial losses. Before acting on any financial or investment matter, you should consult your own qualified professional advisers, who can evaluate your particular circumstances, objectives, risk tolerance, tax situation, and legal needs.

If you are interested in working with Mr. Kennon and Kennon-Green & Co., he would love to hear from you. There is no obligation, and the firm treats all prospective-client inquiries as private and confidential. Please contact the firm directly for more information. To satisfy applicable regulatory and recordkeeping requirements, any individualized discussions concerning the firm’s services are conducted through Kennon-Green & Co.'s approved communications channels rather than through this personal website.

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Reader Comments (52)

Comments are presented chronologically, with replies indented beneath the comments to which they respond.

Austin from TX

January 6, 2016

Reminds me of the time someone working in money management told me that he was making good money off "day trading the 3X junk bond ETFs". I looked at him for a couple seconds to see if he was joking- he wasn't.

Abe

January 6, 2016

This is a refreshing article on the basics of how to invest and why. Thanks!

Ang

January 6, 2016

Making my way through Howard Marks' book and letters currently, so risk management is dominant in my mind (even more so than usual). Though not overtly stated, this article is very relevant to my current state of mind as it pertains to portfolio construction and management. I think a lot of the misunderstandings when it comes to risk is because efficient market theorem (or worse, technical analysis/charting - the past will always dictate the future... until it doesn't) is the first thing most people read about and study. They base their risk assessments on beta and volatility and it's just bonkers. Probably because the theorem/hypothesis is so mathematically elegant (physics envy) and as an investor, if you subscribe to it and all its derivatives (CAPM comes to mind), you don't have to put in the extra thousand hours of work understanding that real risk can't be quantified and can come in many different forms (you've written about several of them piecemeal, such as correlation of oil and banking, geography, obsolescence, management, legal with regards to the Company's treatment of certain demographics such as gays and women, etc.), with the number one being overpayment. But even overpaying can lead to a good result down the line if you bought a strong enough enterprise and ignored the volatility noise along the way.

I do admit though, it's exhausting thinking about then tracking it all - so for most people, an index is the best risk (and time) adjusted way to own equities because of low turnover, low costs, and wide diversification. People just like to over do it and turn it into a religion - to the point where the visceral reaction is: All Low Cost Indexs (Latin American/Southeast Asian small cap bond funds included) - Good, All Individual Stocks - Bad. Reminds me of folks who place hyper focus in their diets on very narrow criteria, such as avoiding "inflammation" or "acidity". I mean yeah, excessive amounts of either isn't good for you, but without any inflammation, your body won't be able to fight off infections, and if you actually manage to turn your body more alkaline than it's suppose to (which is pretty much all but impossible to accomplish since our body regulates the blood PH levels), you... well, die. Foods that belong in non-inflammatory and alkaline diets tend to be things you should be eating large amounts anyways, such as fruits and vegetables, and this tends to be why the diets work. But people take something intelligent and warp the reasons for doing it entirely out of line and you end up getting undesired results because of it.

Kapitalust

January 7, 2016

Replying to Ang

On the line of thought on people taking things (indexing, diets, lifestyles, etc) to the extreme: this has been on my mind a lot lately and I wonder if it is some sort of inherent need in the human species to maintain consistency.

I can't remember where I came across it but I recall reading that consistency is a very important survival trait to possess: one does not want to be wildly inconsistent as it may be an indication of a brain defect, personality defect, or some other form of defect. I imagine people are generally disturbed by highly inconsistent people as they can be a danger to your and the group's well being.

Therefore, I wonder if we are all subject to an extent to some sub-conscious need to be consistent. And from this, leading to herd behaviour, taking things to the extreme, etc. I joke often that it must be liberating to be ignorant and just going with the crowd. I'm plagued by so much inconsistency and paradoxes I see in the world that I have a hard time ever accepting any position fully to any strong extent. It's burdensome to always be thinking of the other side, the other angle, or attacking your own position.

Don't get me wrong: I think it's the only sane way to approach reality. But it is sometimes very tiresome. Being conflicted and seeing two sides of an issue all the time can be a little unsettling. I have a hard time being consistent in my own mind with my values and beliefs. They are constantly shifting as new information and perspective come in. Anyways, I think I am the one blabbering on now!

Ang

January 7, 2016

Replying to Kapitalust

I agree with you and I feel your pain. It is very tiring, but I think allowing your own beliefs to be destroyed over and over again is the only rational way to behave in life. It's been working wonders so far, hopefully at some point in the future it will get easier as the framework crystalizes

Joshua Myers

January 8, 2016

Replying to Kapitalust

Check out the book "Thinking Fast and Slow" if you want an in depth look at the topic. It's a dense read, but definitely worth the work.

Kapitalust

January 9, 2016

Replying to Joshua Myers

It's on my endless pile of half-read books - I think this will give me the motivation to finish it up in the next few months.

onlyalittle

January 12, 2016

Replying to Kapitalust

Strange--I feel the same way Ang does regarding the whole diet thing...I've always marveled at how fanatic people can be about the paleo, vegan, whole 30, low-calorie, low-fat, anti-inflammatory and all those other diets out there. I admire how dedicated and how certain people seem to be about these things, but I've never been able to share in it.

I'm sometimes afraid that thinking this way about a LOT of things marks me to others as wishy-washy or indecisive. It's not that I'm indecisive, though--it's really that I can see multiple sides of one issue. This makes it hard for me to "win" arguments with people as I can usually see where they are coming from (no matter how off-base they may be), even when they can't see mine. And then acknowledging this leads to their assumption that I'm admitting that I'm wrong. (I have a hard time with people perceiving that I'm wrong if it means that me and my point loses credibility with them, and they won't even consider it as a result.)

Anyway, yes it is tiring, in more ways than one. It can be a lot easier emotionally to continue down a path that you're certain about (even though it might be wrong) than to have to course correct for all the new information you get about something. I think that's why I stuck with the religion my parents raised me in for almost a decade after I stopped fully believing in it.

todd

January 6, 2016

My uncle put his stock buys and sells on recipe cards dating back to 1962 and I have them now. While looking at them I try to figure out what he was thinking. Example Walgreens he bought 100 share in 1965 for 2,750 he bought and sold it over the next 45+ years but if he just held the 100 shares and never sold today my Aunt WOULD be holding 51,200 shares worth 4,044,800 million not including dividends. Did he sell to diversify which did cost him a lot of money. This is not the only one there is Phillip Morris and more great companys he bought and sold. Even though my Aunt still holds these great company's she would be much better off if my Uncle never sold. There where some that no longer around but the winners out weight the losers. I use Morningstar to back test my Mutual funds for different dates and compare them with each fund and also my individual stocks I hold. What I have learned is that buy and hold and I mean Hold. Because I never know when I might sell the next Walgreens, Phillip Morris and many others. I love Joshua's Ghost Ship concept. I would love to get a hold of Ronald Reads activity records they would be fun to go over.

jack's smirking revenge

January 6, 2016

I really like your arguments here, and I certainly don't want to own Facebook! I guess the main reason I don't put most of my savings into individual quality stocks is because I don't have the ability or time to determine what's a good value at present time. Sure, I read some suggestions sprinkled throughout your blog, and there are endless value stock lists online, but what am I supposed to do? At least with an index fund I can get diversification with the time I have. Perhaps you could start keeping a (infrequently changed) "buy list" on your site?

Steven

January 7, 2016

Replying to jack's smirking revenge

Following Joshua's blog - as you have alluded to - can give you a buy list over time.

All of these he mentioned - "you split it into five $1,000 piles and pick up extra shares of Hershey,
Johnson & Johnson, Procter & Gamble, Nestle, and Coca-Cola." - are in my brokerage account. Plus Diageo too!

I'm sure Joshua would be horrified to hear it, but I'm sure there are a quite a few of us using his blog posts to provide us with investment inspiration. When he mentions a particular enterprise as selling at a good price I take notice.

Brendan

January 7, 2016

Replying to Steven

I think many do, but that still has to pass through the filter of what your individual goals are. Far more useful here is the insight into how to think as a value investor coupled with other resources, like Ben Graham's publications. I think if one just simply bought because Joshua mentioned it would be foolish, because 15 years from now, if company xyz runs into trouble, you'll have no idea how to intelligently act if you can't value it yourself.

Mike

January 7, 2016

"They buy ETFs that have horrible structural risks (e.g., employing leverage or designed for speculation in that they reset on a daily basis, making long-term profit a mathematical impossibility for reasons they don’t understand)."

Hi,

Could you elaborate on this statement more? Especially the comment about long term profit being a mathematical impossibility? Thank you. I find your blog to be very helpful and a pleasure to read.

All the best,
Mike

Kapitalust

January 7, 2016

Replying to Mike

Here's an article back from 2009 talking about the dangers of leveraged ETFs and how they are basically nothing but a casino product intended on exploiting people's compulsiveness to gamble as opposed to rational asset accumulation.

Here is a link to one of these products.

These things boggle my mind. It is pure speculation. Might as well just be at the casino.

Jay Young

January 7, 2016

Replying to Kapitalust

Here's an article from Joshua's About.com site:

http://beginnersinvest.about.com/od/exchange-traded-funds-etfs/fl/Leveraged-ETFs-for-Beginners.htm

Joshua Kennon

February 11, 2016

Replying to Mike

It's complicated but it has to do with the leverage costs and other expenses combined with the daily reset mechanism, the latter being the main culprit. Every day, the portfolio is rebalanced which means losses are effectively locked in permanently. The extent of these forces working together can be truly horrific.

Let's look at the the prospectus for the Direxion 3x Leveraged S&P 500 ETF. You can find the PDF full prospectus here. On printed page four, right hand column, you get a rundown of how this methodology influences results. For example, in a year when the S&P 500 broke even and volatility approximated 25%, a person who bought and held this ETF would experience a loss of 17.1% of their investment. In a year when the S&P 500 broke even, If volatility approximated 75%, the buy-and-hold investor would suffer a catastrophic loss of 81.5% of his principal. Imagine how much worse it would be if the market was actually down for the year, as it often is.

Unlike buying a diversified basket of stocks outright, where risk reduces with time, the methodology used to construct these leveraged ETF trading tools means that risk increases with time. The longer you hold these securities, the greater the probability of a total wipeout. You couldn't hold one for 10 years if you wanted to as your particular position likely would be obliterated long before then even if the market itself doubled over the same period.

Direxion isn't doing anything wrong. They've designed a cheap, efficient, liquid speculation tool for wealthy investors and hedge fund managers who want to gamble, who know they are gambling, and who are willing to suffer the consequences on a 1-trading day bet without having to deal with the risk of margin calls. The fact that so many inexperienced investors are buying these with the intention of holding them, ignorant of their structure, is nuts. It's a bit like radioactive material. It serves a purpose in the right hands but if you acquire it and have it hang around, the longer it's there, the more danger you're in until it finally kills you. To put it bluntly, there is almost no mathematical scenario within the realm of reasonable probability that would allow someone to make a profit on a buy-and-hold basis once you start extending holding periods out to several years. People sometimes don't grasp this for the same reason they don't grasp the bat and ball problem. They were never trained to think mathematically and just assume slapping 3x leverage on an index means you'll get 3x the results either way minus costs. On the surface it might sound reasonable but leveraged ETFs don't resemble anything like it at present.

In fact, I'd go so far as to say outside of a handful of extraordinarily rare situations, I'd fire any asset manager, wealth advisor, or financial advisor on the spot who had them in a portfolio. There is no justification - none - under any scenario for 999 out of 1,000 investors to ever own one unless they have a side speculation portfolio they treat like their Las Vegas fund and has nothing to do with their core wealth.

Sebastian

January 7, 2016

Great article, as usual! Really got me thinking about reevaluating how I’ve spread out capital across different companies, industries, geographies (and time!).

One thing I can't quite wrap my head around is the risk/reward of investing in different companies competing within the same industry or that operate in similar markets where there may be some overlap. If I invest in more than one company within that space, is my money essentially competing with itself or am I just spreading out the risk?

I would be really interested in how everyone views this.

Eric

January 7, 2016

Replying to Sebastian

It can work if the industry is a rising tide. For example, around 2008 Berkshire owned both Union Pacific and BNSF stock, but when they purchased BNSF outright, they were forced to sell Union Pacific.

Ang

January 7, 2016

Replying to Sebastian

Fortunately, businesses aren't zero sum, if a firm is good at creating value, it doesn't matter if there's a competitor that's also creating value. By holding multiple companies in the same industry, you're also diversifying from company specific risk - ie Wells Fargo and US Bank have different geographic risk profiles. You just have to take one more step and think about your weighting by industry as a whole. Besides having an adequate weighting to Wells and USB, say 3% each, are you over exposed to banking in general? Additionally, companies in the same space can also create value through different means, targeting different demographics within the general population. Think about Coke and Pepsi, they are technically in the same space, but Coke compounded its wealth through beverages, while Pepsi did it by diversifying into snack foods

This article is a good memory refresher of that fact: https://www.joshuakennon.com/pepsi-vs-coca-cola-investment-returns-lifetime/

Joshua Kennon

February 11, 2016

Replying to Sebastian

To understand my thoughts on the matter, read this post from back in 2012.

What matters to you, as an individual and for your household, is the amount of cash being generated by the assets you own. Certain industries and sectors have extraordinarily good economics and have tended to stabilize into duopolies or tripolies; e.g., Visa, MasterCard and American Express account for almost all credit card processing network activity, Coca-Cola, PepsiCo, and Dr. Pepper Snapple account for almost all carbonated beverages, Diageo, Brown-Forman, and Pernod Ricard account for a super, super-majority of distilled spirits, etc. I don't think about acquiring shares in these duopolies / triopolies as competing against myself but, rather, as buying entire superior industries.

Take the Dr. Pepper Snapple / Coca-Cola / PepsiCo example. In one of my brother's retirement accounts, I have long had him be a shareholder of all three. It's almost impossible for the typical American to avoid putting cash in his retirement account each year because someway, somehow, they are going to drink one of those firm's products. All three have beautiful economics. All three are locked in a system where they compete but not too hard because everyone is making so much money. All three have advantages that would make them very hard to displace. If one were to fail, the other two would probably pick up the slack almost instantaneously so the loss wouldn't be as great over the long-term as it otherwise would have been.

The only time this approach becomes a problem is when you have people like Warren Buffett trying to do it. He doesn't - he's loyal to Coke - but it would be bad for society, bad for the economy, bad for retailers, bad for distributors, and bad for consumers if he were to own both Coke and Pepsi. It's a problem that virtually no one is ever going to have to face and when/if they do, that's why we have government regulators to break them up or forbid certain mergers and acquisitions; to keep capitalism working and functioning.

As a matter of fact, when I come across a really, really good business with extraordinary economics, I tend to look around at its competitors and related firms because, frequently, the conditions of the industry or sector are what make the high returns on capital possible. It isn't an accident that over the past century, shipbuilders have nearly all caused folks to go broke while alcohol distillers have minting millionaires like it was going out of style. To be perfectly frank about it, I get a bit of a psychological thrill knowing it. I like the idea of knowing no matter what you choose, you're still putting money in my pocket.

This doesn't hold for all industries - e.g., I wouldn't want to own all restaurants equally, but rather, specific firms with extraordinary economics and advantages. But, in the right industry at the right pricing, I'm a fan of buying the leading two or three firms and treating them as a "Group" (that's actually how I have them labeled on internal spreadsheets - "Alcohol Group", "Food & Beverage Group", etc.)

Rob

January 7, 2016

I wish I had known about XRay earlier; helpful tool

Ang

January 7, 2016

Replying to Rob

Very nice portfolio you've got there - I'm surprised at the size of Exxon even at its current price, could become an outsized part of your portfolio if/when oil turns in a few years

Rob

January 7, 2016

Replying to Ang

Thank you. I agree, I have 2-3% weightings in CVX and BP as well...could become very interesting in the next few years, if not a little longer. At 32yrs old, plenty of patience.

Brendan

January 7, 2016

Replying to Rob

I'm a year behind you but in the same boat with XOM. Collected my first dividend...reinvested actually...from my dspp I started with them. I actually get more excited as oil keeps falling. I've also picked out a handful of other blue chips to aqcuire when their prices become attractive. And even though I still have to work a full time job, it's still fun to grab an annual report or two and delve into a business and start to work on a buy price range, knowing that eventually these little seeds will provide effortless income down the road.

Rob

January 8, 2016

Replying to Brendan

That's the way to go about it, in my opinion. I have hard copies of the annual reports sent to my house, kept in the garage so i can quickly refer back if need be. There is something fulfilling about having the hard copy show up at your door, and being able to thumb through it rather than just reading on a screen. At our age, we are buyers/holders; enjoying the price drop for some quality companies.

Stephen H

January 8, 2016

Replying to Rob

I've been using Notability on my iPad so you can open them in pdf, make your notes and comments (I use an Adonit Jot Pro.. It's an ok stylus) then let it sync to whatever cloud choice you have so you can review etc. Saves paper and let's me use that expensive device a bit more, haha.

Joshua Kennon

February 11, 2016

Replying to Stephen H

I just started using Notability for my handwritten notes (not so much for PDF's though I've been experimenting with it versus iAnnotate) and absolutely love it. I wish there were a way to make custom paper colors and ink colors, though. That seems like a horrible oversight and so easy to fix.

Stephen H

January 8, 2016

Replying to Rob

I find I have a heavy weighting to Consumer Staples. JnJ may be considered Healthcare under GICS but still has CS exposure which makes it worse for me since its my biggest holding as far as individual securities are concerned . But, yet, holding lots of CS doesn't keep me up at night one bit.

Joshua Kennon

February 11, 2016

Replying to Stephen H

Consumer staples fascinate me because they reveal so much about human nature and the problem of economics versus behavioral economics. Over long periods of time, with dividends reinvested, the sector tends to crush most other parts of the overall market and, icing on the cake, does it with far lower levels of risk - if they fail, we are truly, totally screwed as a country. Yet, when the stock market begins to boom, they tend to be left behind the bad businesses, which suddenly find themselves on the favorable side of operating leverage so their share prices explode. This causes the consumer staples to tend to lag the broader market in the early stages of good times when they develop reputations for being slow "grandma or grandpa" stocks; boring firms that pump out money but won't make you rich overnight.

Everyone becomes so obsessed with falling behind the benchmark in the short-term they ignore than over 10, 15, 25+ year periods, the wealth differential is fairly enormous. In other words, they focus on the scoreboard rather than the playing field, to borrow an analogy. You get this outcome where, by trying to do well relative to the market in the short-term, they never stop to ask themselves, "What is going to make me the wealthiest with the lowest amount of worry over the next few decades?". They care more about temporary measurement than substance or relative performance to friends, family and strangers than absolute performance.

Alcohol is another one of those areas, too. It's more economically sensitive but if you look at the long-term returns, especially in countries like the United Kingdom which avoided the interruption period of Prohibition the United States saw in the early twentieth century, the cumulative and aggregate outperformance of the distillers and brewers, due to obscenely high, sustained returns on capital, is completely obscene; orders of magnitude more wealth over generations. Nobody seems to notice or care except a handful of academics and rich families. Whenever firms like Diageo or Brown Forman get within fair value range, all a person has had to do, historically, to get very, very rich over time is add shares and lock them in a bank vault or custody account somewhere. They take water and sell it for exponentially more than the input costs. It's a license to print money. Whenever I add it to our household balance sheet, I intend, absent some current unforeseen circumstance or opportunity, to hold it for the remainder of our lifetime.

Johnson & Johnson is particularly fascinating. A lot of investors don't realize how it is structured - it is, in many ways, the original Berkshire Hathaway. The company itself - the one you own shares in - is really a holding company. It, in turn, owns the controlling stock and membership interest in a wide range of subsidiaries around the world. Those subsidiaries are managed and operated on the local level by local employees in local markets so you get the entrepreneurship effect and culture code aspects harnessed. The capital is sourced by the board of directors at the top to provide the lowest-cost funds available, all else equal, and manage political risk. It has one of the top ten strongest corporate balance sheets on planet Earth when looking at mega and large cap corporations. Were I forced to own only a handful of stocks for the rest of my life, and never be allowed to buy or sell more, it would certainly be on that roster alongside Coca-Cola.

Stephen H

February 11, 2016

Replying to Joshua Kennon

Thank you for the reply. Just quickly on the note about distillers, I keep eyeing up DEO and I think it's starting to look attractive. It's a real gem when you look at the bigger picture and its house of brands. CL is on my hit list, should have hit more Hershey in the last couple of weeks also. So much volatility means so many opportunities!

Joshua Kennon

February 11, 2016

Replying to Rob

That is a truly beautiful collection of assets you have there. I found myself smiling as if I were looking at a painting or sculpture I liked in art museum. You don't need me to say it but I will anyway: Well done! All are among the strongest firms in their industry with rock-solid balance sheets and high returns on capital. All possess substantial entrenched advantages that would make them very difficult to unseat. All are geographically diversified. All are reasonably valued based on present known factors for a 25-year old owner so no matter what happens tomorrow - if you woke up to find them 50% down from their present levels - the odds of permanent capital impairment are most likely extremely low. This makes me so happy.

Josh

January 8, 2016

Joshua,
Love the site and this was such a wonderfully written article... tremendously helpful.
I'm wondering if you can resolve one discrepancy though. You stated you wouldn't want to buy Chinese stocks in general and specifically mentioned a 2.5% earnings yield, presumably to demonstrate their high valuation relative to underlying fundamentals. You then went on to laude Hershey for her wonderful fundamentals and how at today's price (roughly $85.50), you're supremely confident in the return potential. At this price, Hershey is also training for about the same 2.5% earnings yield (well, 2.6%). Can you clarify the difference? I understand HSY's fundamentals to be exceptional but isn't this still a case of a wonderful company and a bad stock?
Josh

Ang

January 8, 2016

Hershey's income currently has a one time charge against intangibles due to devaluation of their investment in Shanghai Golden Monkey. If you go to the third quarter 10-Q and look on page three (the income statement), you'll see $280m of goodwill impairment and an extra $60m charge against business realignment over prior year. Adding this back to net income of ~$300m results in EPS more than doubling, which results in an earnings yield of 5%+

Joshua Kennon

January 8, 2016

That's a great question. I had a discussion about it with someone in the comments section of the Lindt White Chocolate ice cream recipe post (one of the weird things about this site, since it really isn't an investing site per se but my personal blog so the conversation goes wherever it goes, is that some of the more detailed financial discussions happen in posts that are seemingly not related to the content itself - something that a forum (which, yes, I'm still working on despite it falling to the back of the priority line at the moment) would solve.) Check out that thread for the specific answer you're seeking.

The short version: There are some temporary accounting things going on with The Hershey Company that caused reported net earnings for the recent period, and thus the earnings per share figure that is filtered into the financial portals, to appear artificially low and not at all indicative of the core economic engine. Real, sustainable, long-term profitability is substantially higher than it appears at the moment. To put it more bluntly, the "E" in the "P/E" ratio is not accurate. Despite what brokerage firms and financial sites say today, Hershey is not trading at a P/E of 37.53 or the corresponding earnings yield of 2.66%; not even close. The actual earnings yield is a bit over 5%. For an owner with a really long-term, multi-decade horizon, I'd go so far as to say it's one of the most attractively valued components in the S&P 500 on a risk-adjusted basis at the moment.

This is the reason you can't rely on stock screens or simplified tests to find attractive opportunities in isolation. Hershey wouldn't show up at the moment but if you know how to value a business, can understand how to read financial statements, and all of the other stuff that goes with it, you can pull the 10-K filing, dig in there, and look at it like a private business owner, answering the question, "If I could buy 100% of the firm, what would I pay if I wanted to guarantee myself a high probability of a satisfactory result, present known factors considered?".

You run into this sort of thing all the time. With certain types of industries, there is a phenomenon known as peak earnings that causes the stocks to appear cheapest when they are, in fact, most expensive. You can't just look at the numbers, you have to know what those numbers mean. With earnings: Where are they coming from? What is the sustainable, expected free cash flow in different types of economic environments (e.g., a fantastic business like Hershey is going to have a much easier time than an equally as wonderful business like C.H. Robinson Worldwide which, despite its mouth-watering economics, is much more economically sensitive so something like a Great Depression would hit intrinsic value harder and faster)? How good is management at converting that into increases in intrinsic value or dividend increases, driving total return? What are the existential threats to the industry (e.g., a horse and buggy manufacturer might look profitable but if you notice the automobile start taking over the road, it's indicate of a change in the supply/demand inputs)? The game comes down to buying the most owner earnings you can at the most attractive price, adjusted for risk and time, then intelligently constructing your "collection", so to speak, so that a few inevitable failures along the way (you cannot know nor predict everything) don't have a meaningful influence on your standard of living or ultimate wealth accumulation.

Sometimes, there are systematic things that result in a lot of opportunities. For example, up until the last ten or fifteen years, there were some quirks in the accounting rules that caused the reported earnings of pharmaceutical companies to almost always be lower than the real, owner earnings. This made pharmaceutical stocks, on the whole, much more attractive than they would otherwise appear (and was partly responsible for the long-term outperformance of that industry). During the 1990's, the gross abuse of stock options as a form of compensation without the requirement to recognize them as such caused the real earnings of technology firms to be substantially lower than the reported earnings, meaning the already obscene p/e ratios were actually even worse than many people realized. The p/e is useful shorthand but what really counts is p/oe, or price to owner earnings.

Josh

January 8, 2016

Replying to Joshua Kennon

Thanks for the "short explanation!" P/OE has a 5.5% yield, which is far more enticing and, I'm assuming, far closer to the real value of the business. I should've known better and clearly need to continue learning about what counts in earnings.
And thanks, Ang, for the specifics on the charges against earnings and the reconciliation. Very useful!

todd

January 9, 2016

I thought I would share with Joshua and all on this blog about my Uncle Receipe cards. Dated 10-13-65, 30 shares at 29 dollars a share of Cincinnati Gas & Elec. Merged with PSI Resources Oct. 25, 1994 to become Cinergy Corp. Change name to Duke Energy May 2006. Split Off Spectra Energy to Duke Shareholders 1-2-07. My Aunt is still holding these two companys.
Just think my Aunt has been holding these for 50 Years now that's longterm! If it's ok with Joshua I can share more on this blog of my Uncle Receipe Cards. They date back to 1961.

Joshua Kennon

February 11, 2016

Replying to todd

By all means, feel free to share anything and everything you want. I love things like this. I could read about them all day!

todd

January 10, 2016

Correction my aunt would have 25,600 shares not the 51,200 I put in early post I figured a extra 2 for 1 stock split. Value at 2,074,880 dollars as of 1/8/2016. There was a extra 2 for 1 split in 1963 but that was before my uncle had bought it. 13.476% annual return not including dividends.

Joshua Kennon

February 11, 2016

My favorite analogy of all time is thinking of a portfolio like a car insurance company thinks about its policy book. When a car insurer writes an automobile policy, they know some of the customers are going to get in accidents. They know some of the policies are going to go bad. However, when the policy book of business itself is intelligently designed, the overall result should be more than satisfactory. A portfolio of securities is very comparable.

Buy and hold investors who focus solely on really, really good companies with real sales, real profits, and major competitive advantages understand this. They aren't scared of a bankruptcy or two along the way because they get that, like your Philip Morris illustration, one or more of the firms can result in such incredible outperformance it makes up for those that suffered demise along the way. Few people have the right temperament. It takes a strong will to stick to your guns and do what works when the whole world is screaming at you to buy or sell on any given day. Some people aren't equipped for it. A buy and hold investor is perfectly willing to watch a position go to zero knowing, long-term, it shouldn't matter much.

Imagine you were building a ghost ship and bought $10,000 worth of 10 different stocks. Immediately, one of them goes bankrupt. However, 25 years later, each of the surviving companies had managed to compound at a 10% rate of return (let's use a general average estimate that is neither on the low nor high end of historical experience for periods of that length), you'd end up with $975,124 or so, which is a compounding rate of 9.5% even though you had a fairly horrific failure rate - 1 out of 10 positions, which is very high. What's really crazy is that if even one of those positions turned out to be a Coca-Cola, Colgate-Palmolive, Microsoft, Nike, Home Depot, etc., the overall compounding rate of the portfolio would actually exceed the average compounding rate of the individual components. That's the reason that you could almost (if history continues to repeat itself) assuredly beat the S&P 500 by a meaningful amount over 25 to 50 years if you were to simply buy all of the components, equal weight them, and never make another subsequent change. Historically, whenever this has been done under almost all conditions, the end wealth is much higher than an index fund tracking the same index. Folks don't realize how actively managed index funds are compared to true passivity.

There's only one mainstream publicly traded mutual fund to my knowledge that has ever used this approach. It's now called the Voya Corporate Leaders Trust; the ghost ship approach you and I have discussed in the past and which you mention in your comment. It is completely, totally passive. It charged a 0.50% management fee for years and years and years to take care of all of the small details, tax forms, and paperwork. It totally left the S&P 500 and Dow Jones Industrial Average in the dust despite underperforming it over certain multi-year periods. Most people wouldn't have been able to hold it. Even if it means higher results in the long-term and on the aggregate, they cannot deal with watching one of their holdings go into bankruptcy (which should be rare if you're demanding good earnings, a strong balance sheet, and, in many cases, a healthy dividend record from each of your ownership positions). They cannot deal with being behind the index for 3 to 5 years. They can't focus on the forest for the trees. It's a behavioral problem. That is why I talk about temperament so frequently. Temperament is so much more important to investing than intelligence, education, or connections. Temperament is the secret.

The thing I find fascinating is, you never quite know which of your holdings is going to wildly exceed your expectations. You can make guesses as to probabilistic range outcomes based on the price you paid and likely earnings but there's always a degree of uncertainty. I suppose it's a bit like a farmer planting crops. You get the conditions right, you tend your fields to make sure things are in order, you make sure you're only planting the best seeds you can find, then you let time do most of the work. Storms will come. A few plants will be lost to frost. But every once in awhile, some ordinary looking oak tree ends up exceeding your wildest expectations. It's a Pareto's Law of Distribution thing. It's like Dolly Parton saying she won't sell her publishing rights because she doesn't know which of her songs will turn out to be a hit. I see it in my writing copyrights, too. Years and years ago, there was a single, relatively short article I wrote; took no time at all to pen it, didn't think much about it compared to other pieces I spend extended periods of time focusing on and revising. It wasn't anything particularly special but, for whatever reason, it became extremely popular and ended up producing tens of thousands of dollars in cash advertising income; money pumped out month after month, year after year for me to spend, invest, save, or donate. Life is funny.

todd

February 11, 2016

Receipe card #2 American Brands Inc. Bought 9-13-67, 50 shares $34 per share commission $22.15 Cost $1722.15
2 for 1 split 5-5-81 an 9-10-86 , Sold 200 shares 11-19-86 for $41.25 a share commission 123.29 total sale $8126.71 after commission. rate of return 8.426% over the 19 years. I don't know if they paid a dividend during those years. I Don't know what happen to the company after he sold the stock.

Joshua Kennon

February 11, 2016

Replying to todd

American Brands began as The American Tobacco Company in 1890. It changed its name to American Brands in 1969 and ended up expanding its alcohol, tobacco, sporting goods, and other businesses. It later changed its name to Fortune Brands. It ended up selling off a ton of assets then breaking itself into two businesses, one called Fortune Brands Home Security [ticker symbol FBHS] and one called Beam (maker of Jim Beam) which was acquired by a Japanese firm at a rich valuation.

It was one of the greatest investments of all time. If you held all of the spin-offs and divestments, plowed back the dividends, etc., it was up there with Hershey, Heinz, and Colgate-Palmolive. The last time I saw someone analyze it over the long-term was when Jeremy Siegel did his original S&P 500 research and found that between 1957 and 2003 (or thereabouts - whatever his original parameters were), it compounded at a jaw dropping 14.55% for that nearly half-century period. My guess - I'd have to run the actual numbers and it would take a long time given all of the moving parts - but that stake, held to today, would have been worth somewhere between $500,000 and $1,000,000 easily.

What impresses me is the fact he held onto it during the catastrophic 1973-1974 period when equities saw a 50% to 75% decline. He truly behaved like a business owner. This sort of thing makes me so happy!!!

todd

February 11, 2016

Reciepe card #3 Savings Bank 6 month $10,000 CD Dated 2-13-1981 14.68% Renewed 8-14-81 at 15.372% Renewed 2-12-1982 at 14.183% Cashed in 8-13-1982 for $12,371.74 Can you believe those CD rates back then.

Joshua Kennon

February 11, 2016

One of my favorite investment thoughts is the fact that somewhere out there, there exists a lot of investors who bought 30-year Treasury bonds in October of 1981 when yields hit 14.68%. They had to do nothing for the next three decades as inflation settled back down to normal and they were drown in that beautiful stream of cash; obscene, offensive amounts of passive income that never required them to read an annual report or worry about anything other than the long-term survival of the United States of America as their asset was backed by the full taxing authority of Congress. I thought about that more than a few times in 2011 when they came up for maturity. It was easily one of the best investments of the entire 20th century.

I'd love to see rates at 5% to 6%, again. The Federal Reserve has been so terrified of allowing us to suffer pain that we keep kicking the can down the road and dis-incentivized saving. I remember when I was younger and the cash balances in a brokerage account would collect that 5% to 6% in money market dividend income. It was wonderful. You got paid to wait and find something attractive. Now, they're talking about introducing negative interest rates to punish people for keeping money in cash ... to force them to spend or invest it.

Ang

February 12, 2016

Replying to Joshua Kennon

Joshua Kennon sighting in 2016! ; )

Good to see you around and commenting. It's a little funny since because the only signs of activity we have from you are this blog and about, when you disappear for a little bit then start unleashing a torrent of comments, it reminds me of cabin fever, and in my head I have a very exaggerated image of you running around with a giant smile on your face because you've finally been exposed to some sunlight after being locked away in a publishing dungeon for two weeks. Hope you've gotten all of the work you wanted done for About and your fund.

I think the 30 year treasury bond from 1981 is fascinating, because I would have loved to see what actually happened as equities started to take off. My guess is most people (besides the really old and conservative) started suffering from large amounts of envy and sold out to buy equities, but it would be interesting to see. (They could have taken the yield and invested that instead, and would have had a very good result too)

The Fed seems to be a little bit stuck, just as they wanted to start putting their foot on the gas, central banks around the world have begun their own easing. I think they will be too afraid to enact their original plan. While it's not rational, I understand why the mandate is "reduce volatility", such a majority of the population just can't handle it, for a myriad of reasons. Of course, that doesn't make it right, as Charlie likes to say, if you can't handle it, then you deserve an inferior result

dave(lower case) (nestle)

February 12, 2016

Replying to Ang

Haha. Believe it or not I have not checked the blog for days and days. I have been down here in Florida for the last week(at the happiest place...) and I have kept the side of one of my eyes peeled just in case. The Nemo clamshell ride at epcot made me decide to see whats going on here. Well He wasnt in 'France' where we just shared some great pastries and coffee...

Todd

February 11, 2016

Last one for tonight Receipt card #4 Putman Voyager Fund Date 5-8-69 100 shares at $11.61 a share total cost $1161.00 Sold 2-6-89 , 444.916 shares for $9507.85 Rate of return 11.23% This is the only Mutual Fund he had on his Receipt Cards. And yes my daughter corrected my spelling of Receipt. 🙂 and told me to capital my name.

Roundball

February 11, 2016

Joshua, you've often mentioned the "private market value" of a company (eg- in your Colgate post from last summer, you posited that even though the P/E ratio looked expensive, Colgate appeared slightly undervalued to private market value if you could get your hands on the entire empire). What is a rational way to evaluate the private market value of a security? Do you apply a multiple to owner earnings or are you applying a premium to current market cap? Thanks!

Todd

February 12, 2016

Receipt Card #5 Date 12-13-1961 40 shares of Iowa Southern Utilities Co. $40.25 per share 2 for 1 split 7-25-1963 , 2 for 1 split 6-12-1986 Sold 10-25-1990 for $32.00 a share. 160 shares less 67.35 commission. Rate of return 3.68% not including dividends which I guessing 4% so total return 7.68% This is his oldest Receipt Card.

Todd

February 12, 2016

Receipt Card #6 Date 6-5-1968 30 Shares of S.S. Kresge Co. $97.00 a share commission $31.70, 8-14-1968 2 for 1 split , 6-30-1972 3 for 1 split. This card is confusing it shows he sold 906 shares 7-25-1986 at $55.00 per share, on the back of the card he wrote Bought 6-5-1968 for total cost $5109.49 sold 7-25-1986 Total less commission $49,415.65 , Rate of return on this is 13.339% Joshua would know S.S. Kresge Co. change its name to later. Any one on the board know? There are more Receipt cards with home runs but I will save them for later and some I don't know what happen to the companys. Will post more at later dates.

Adrian Burns

February 29, 2016

This post was a bit of a wake-up call. My brokerage allows access to the premium X-ray features and I was able to zero in on my holdings as suggested in this article.

Because my 401-K investments contain the bulk of my assets and are actively managed I've discovered that I have a whole lot more growth companies than I thought. Amazon is currently my second largest position.

This hit me hard as I'm a listener to the various Motley Fool podcasts and they're BIG fanboys of Amazon, a quality that really irked me due to its high valuation and how often they proclaimed its superiority no matter the subject matter. And lo and behold there I am holding a whole lot of Amazon without knowing it.

After investing primarily in indexes (the aforementioned 401-K investments aside), I started investing in some individual stocks last year (using LOYAL3 and Computershare) and feel I'm lowering my expense ratios and adding quality to my portfolio like Joshua wrote in the article...the info was both timely and helpful. Thanks.

Ang

June 30, 2016

Hershey's up 20% today based on buyout rumors - This is a bit upsetting - Having your investing fortunes tied to Irene Rosenfeld isn't the best

Alex Y

July 6, 2017

Well written! I would venture to say that most people have little understanding of finance. There's a learning curve when it comes to investment theory and there are many people who have not obtained a level of knowledge necessary for them to even begin to pay attention to the weightings of the individual components that make up their investment portfolio. It's an important topic though and I applaud you for writing this post.