The 21st century has provided the human race with a previously unthinkable amount of technology and, by extension, data, information and productivity tools. One has to ask, however, if on balance, this explosion of technology has been beneficial to the human race.
Many significant developments have been largely frivolous, such as Facebook Inc FB and Twitter Inc TWTR. Others, particularly those relating to weapons and the tools of war, are ominous. Also falling under this category would be the ever more complex and opaque, yet ultimately ponzi-like, financing schemes that nearly imploded the global economy in 2008.
Of course, there is much that is positive as well, such as the emergence of clean, alternative energy sources and the technology driving critical infrastructure in developing economies. Nevertheless, a fair and objective analysis suggests the sword of breakneck technological evolution cuts both ways. Nowhere is this more evident than the world of finance. The prospect of investing in 2016 can be a truly dizzying undertaking for the average retail investor saving for retirement.
While on the one hand, investors today have access to an unprecedented amount of financial data and information at the tip of their fingertips, the process of assimilating it into a cohesive strategy may be more confusing than ever. In today's market landscape of high-frequency trading, leveraged ETFs, 24-hour electronic trading in markets across the world and never-before-seen levels of global central-bank intervention, how should an investor approach obtaining a reasonable rate of return on their capital?
In this article, a handful of simple rules any investor can use to implement a coherent and disciplined strategy are explored. Investors can avoid a vast majority of the myriad pitfalls that beset the average do-it-yourself stock picker. If the goal is to build a portfolio of high-quality equity securities that offers a respectable yield, the potential for market-beating returns and a more attractive risk/reward profile than the S&P 500, consider implementing the following six rules.
1. Invest in stocks that offer an easy-to-understand, fairly straightforward company business model.
This is advisable for a few different reasons. First, as an investor, you will be able to make significantly better buy/sell decisions with regard to a particular stock if you have a solid understanding of the business and the levers that drive key metrics such as sales, margins and net income. Second, by avoiding opaque and overly complex business models, investors are likely to avoid devastating outcomes such as fraud, as was the case with Enron, or unseen and hard to quantify risks, such as Lehman Brothers' massive subprime exposure in the wake of the housing market meltdown.
A strong grasp of a company's business model will also help investors ride out short-term volatility and keep a long-term perspective, generate more accurate forward-looking projections and more easily assimilate news, management statements and Wall Street research into an investment thesis.
Furthermore, there are just an awful lot of great companies with extremely simple core businesses. Examples include McDonald's Corporation MCD, Apple Inc. AAPL and Starbucks Corporation SBUX.
This piece of advice is one of the hallmarks of Warren Buffett's long-term investing philosophy. Buffett and his partner Charlie Munger have repeatedly stressed the importance of sticking to their "circle of competency" when making equity investments. It may be wise to do the same.
2. Invest only in companies that are "best in breed."
Typically, these companies are synonymous with quality, have terrific management teams, are admired in the marketplace and are known for being the best at what they do. Investing in "best in breed" companies positively leverages the passage of time.
More often than not, these companies have inherent advantages over their competitors, and over the course of an investment horizon, these dynamics will work in the high-quality company's favor while continuously disadvantaging the lower-quality competitor.
Look for companies that have first-rate, established brands or companies with extremely strong emerging brands. Throughout the course of American business, great brands have been synonymous with terrific long-term investments. Keep in mind, however, that in some sectors, the concept of "brand" means less than in other areas of the market. Branding, for example, is considerably less significant in the mining sector than in retail.
Overall, it's best to stick with preeminent, ubiquitous, and highly-admired brands and underweight sectors where these stocks are hard to find or do not exist. When investing in less "brand conscious" sectors, however, stick with the "best in breed" companies and follow the other parts of the strategy highlighted here. The concept of brands being "moats" around businesses is something that Warren Buffett has spoken about in-depth. Furthermore, if you look at many of the best performing stocks in history, all have one thing in common: a tremendous brand
In addition to the stocks mentioned under the first rule, consider some other examples like Nike Inc NKE, Ralph Lauren Corp RL, Alphabet Inc GOOG GOOGL and The Coca-Cola Co KO.
3. Invest in winners.
While the old investing axiom "past results do not guarantee future performance" is true — and frequently repeated — it's also misleading. In order for a stock to meet the criteria of the investment strategy laid out here, it has to be a strong past performer. It doesn't have to be up over the last year or even a couple of years, but the long-term chart has to be compelling.
Ask yourself the following: Do you want to invest in a business, brand and management team that has destroyed shareholder value over the long term or one that has made shareholders rich?
The answer is obvious. Buy stocks that fit the above metrics and have performed well over a substantial period of time. If you are screening for tremendously-established brands as well as rapidly-emerging brands, this shouldn't be a problem. Most companies that fit this profile have a great long-term track record of creating shareholder value.
4. Invest in mid- and large-cap companies and try to avoid small-cap names.
This is particularly true for less aggressive investors who are seeking solid returns with the same or less risk than the S&P 500 (market risk). This isn't an edict, as there are some great small companies that would fit into this investing framework, but make sure that most of your picks conform to this advice.
Like many of the tips provided here, it aligns with the Benjamin Graham and Warren Buffett school of investing and is primarily based on limiting risk. Conversely, investors who are looking for the highest returns possible, with little to no regard for risk, should fill their portfolios almost exclusively with small-cap stocks.
For the average investor, however, focusing primarily on more established companies will help to avoid catastrophic losses. Furthermore, if you're investing in "best in breed" companies and preeminent brands, following this rule shouldn't be a problem.
5. Try to focus on companies that pay out dividends.
Again, this is not an edict. Technology industry bellwether Apple did not pay a dividend for many years, despite fitting seamlessly into this investing framework in every other way. Google (Alphabet) also does not pay a dividend, but again is a highly recommended stock according to this investment philosophy.
Dividends are important for a number of reasons. First, they can meaningfully boost returns, and a good portion of the stock market's historical return has been as a result of dividends. Also, they have the added benefit of limiting downside risk: As the share price of dividend stocks declines, the yield goes up. As the yield continues to rise due to a falling share price, theoretically, the stock becomes more and more attractive to buyers on the sidelines. In this way, a quarterly dividend can frequently act as a floor for a declining share price.
Examples of great dividend stocks that would fit this framework include Altria Group Inc MO, owner of the Marlboro cigarette brand, and competitor Reynolds American, Inc. RAI, owner of the Camel brand.
6. Ideally, investors should look for companies that operate diversified, high-volume businesses.
This includes diversification of both product lines and markets. For example, Walt Disney Co DIS operates a variety of different media and entertainment businesses, including television channels, movie studios, resorts and theme parks. Furthermore, the company is also diversified geographically, with a large international footprint. Both of these factors give Walt Disney a very strong platform for continued organic growth.
These are compelling investment themes when evaluating individual equities.
Another aspect of a business that investors should weigh is relative sales volume. For example, Chipotle Mexican Grill, Inc. CMG sells a lot of burritos to a large number of consumers at a relatively low price. This is an example of a high volume business. Although these types of businesses generally will have lower margins than say an enterprise software company, their revenues are also much more stable and predictable. Whereas the software company's sales could fall off a cliff if one big customer leaves, this isn't the case for the burrito-maker. And, while Chipotle's sales did actually fall off dramatically in recent quarters as a result of the food contamination crisis at the company, analysts are projecting a recovery and record high sales in fiscal 2017.
Post-Script: On Valuation
Finally, a quick note about valuation and when to make stock purchases. Ideally, you want to buy stocks that fit this framework either on significant market pullbacks or when the stock is breaking out from a large consolidation area or base. The idea of buying on breakouts from large basing areas comes from legendary investor and founder of Investor's Business Daily William O'Neill's CAN SLIM strategy.
In particular, look for this pattern with emerging brand stocks and try to buy the more established companies as cheap as possible to hold onto for the long haul.
The Bottom Line
Is the old saying "nothing ever changes on Wall Street" accurate? The answer is a definitive yes and no. On the one hand, technology has completely revolutionized the investing landscape. Today, market structure is dominated by computer algorithms, which operate on millisecond timelines. Electronic trading has given investors unprecedented, real-time access to a wide variety of asset classes across the globe. Astounding amounts of financial data can be accessed with the push of a keystroke. Brokerage commissions have plummeted, bid/ask spreads are narrower and financial news is ubiquitous.
Many of these developments have helped the individual investor, the so-called "little guy." But, they have also contributed an intimidating amount of complexity and confusion to the process of do-it-yourself investing. This leads back to what hasn't changed and never will change on Wall Street.
In order to beat the herd, a well thought out, disciplined investment strategy is paramount. The framework provided in this article is meant to allow investors to distill the vast universe of stocks down into a manageable portfolio of high-quality securities. By focusing on just a handful of key metrics designed to minimize risk while maximizing potential returns, individual investors can position themselves well ahead of the investing curve.
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