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Today I have an awesome guest post for you by the Duke of Dollars. If you have not started investing yet this is the perfect place to start. These guys break investing down to its simplest form and make it easy to understand.
A Call to Action – Invest Now
This guest post is written by the two authors at Duke of Dollars. Together, we strive to guide our readers to financial independence through knowledge, motivation, and humor.
Your personal balance sheet
When a month ends, a new entry is recorded in your personal balance sheet. If you’re not paying attention at all, it’s a blurry report, but it exists regardless of the presence and accuracy of your accounting records. It’s the official record of the things that you own, according to people who are in charge of validating the ownership of things. Those people keep very accurate records. Some of those people are willing to pay you money regularly to own certain things: assets. Other people expect you to pay them money repeatedly if you own debt.
We believe that everyone has an inherent self-interest to own more of the former than the latter. Achieving mastery over your finances widens the scope of possibilities for your own future, the future of the people you love, and the future of the world around you. There’s a fairly clear-cut road toward shoring up your balance sheet. We’re aiming to light the way and provide some interesting commentary along the path.
Investing: time is of the essence
If there’s one reason that Duke of Dollars exists, it’s to encourage people to build cash and invest it in wealth-building assets.
As soon as possible.
There’s an urgent call to action because starting right now is the most surefire way to succeed with this particular mini-game in life. Not only does inflation drag you down the longer that you have neglected to build wealth, but you also have disappearing annual targets to meet in order to optimize the process. Missing a year’s worth of 401(k) matching contributions, skipping an annual tax break from an IRA contribution, or—most dreadfully—missing a year of compounding your investments: every one of these opportunities that you let slip by in your twenties/thirties puts you at a massive disadvantage later in your financial life. We’re simplifying the decision-making process for building wealth via our Financial Roadmap, which we call Build Your Kingdom.
Related: How to Invest $100
How to invest with confidence
After you’ve spent a few years hitting as many of the annual savings targets as you can, you’ll have a substantial balance to your name. What do you do with this money? That’s where we aim to provide the most commentary to alleviate fear and give people the confidence to invest.
At its simplest, buying a mix of index funds every chance you get and ignoring the accounts for decades will put you far ahead. In fact, that may be the best possible course of action you can take for your investing plan. Feel free to stop right there, repetitively do just that, and you are DONE with your investment research and planning. However, if you get any of the following gut feelings during your investment career, you might want to read further:
- “Well I’m scare the market might drop!”
- “Holy cow the market just dropped 30% in a month; I need to do something!”
- “I’m sure that if I buy this thing, I’ll be better off than buying index funds!”
It’s possible to build a pool of assets that will have better success with less risk and less cost than “buy a little bit of everything all the time” i.e. indexing. Furthermore, it’s imperative that investors understand the psychological and behavioral side of managing a six- or seven-figure portfolio. In other words: you are your portfolio’s worst enemy. Any action you take that deviates from dollar-cost-averaging into index funds has potential to worsen your results. All this said, why will you see discussion about individual stocks on Duke of Dollars?
- Buying and holding individual stocks ALMOST ALWAYS reduces cost
- Buying and holding individual stocks CAN reduce risk
- Owning individual stocks CAN improve the behavioral nature of your investment transactions
Because point #1 may be an exercise in marginal utility, i.e. index funds are already laughably cheap, and point #2 is the weakest of the three arguments, we like to focus on point #3.
When you walk into a bar and see people drinking Diageo beverage brands, wearing Nike shoes, ordering food packaged by Sysco and made palatable by McCormick, paying their bills with Visa/Amex/MasterCard, and scooting home in a steel chariot powered by Exxon/Chevron products: you care much less what “The Market” is doing and much more about the fact that your business holdings are making money.
Regardless of your investing approach, you should internalize this relationship of ownership over your investments. If you own an S&P500 index fund variant, then you own most of the businesses named in this paragraph.
Read Also: The Reality of Frugality
How to choose the right investments
This is the part that takes work. If you want to move beyond “buy a bunch of index funds” then you must read, do math, and research. If you’re not willing to do those things, then it’s in your best interest to stick with “buy a bunch of index funds!” So what do you read? Study:
- Accounting (GAAP)
- The time value of money
- Case studies of Failed businesses
- Case studies of Successful businesses
- Annual reports
- 10K’s – these are SEC filings that all publicly traded US companies must file annually
Purchasing active funds means that you pay an investment management team to select investments on your behalf. Usually, these funds have rough guidelines, but the manager has wide latitude to buy and sell assets at his/her whim. Because people are making these decisions and conducting transactions, the funds are usually expensive compared to index funds as alternatives.
Passive index funds
An index fund is a collection of assets in which you can purchase fractional shares. The composition of the fund is determined by a set of rules. These rules are subject to change over time, but generally, a fund sticks to the same overall concept during its lifetime. One of the most common types of index fund is called a cap-weighted fund, e.g. “Large cap index” and “Small cap index.” These investments have a cutoff range for the size of the company as determined by market capitalization. A company’s market cap is simply the current price per share multiplied by the number of shares outstanding. While market cap funds are most prevalent, index funds exist in many flavors, including breakdowns by sector, geography, and even socially-aware investments.
A common approach to investing is to determine a mixture of funds called an asset allocation. Every investment transaction then follows this asset allocation. For example, a 40/30/20/10 approach might put 40% of all assets into Large Cap, 30% Mid Cap, 20% Small Cap, and 10% Intermediate Term Bond index funds. This approach usually involves a rebalancing mechanism so that when investments grow at different rates, sales and purchases are executed periodically to bring the allocation back to the original. After a couple of years, the 40/30/20/10 might shift to 39/32/24/5 if stocks perform exceptionally well while bonds lag. A rebalancing transaction would shift +1%/-2%/-4%/+5% of assets to realign the original intent.
Read Also: How to get GUARANTEED returns on your money!
Dividend Growth Investing (DGI)
The past few years, we’ve witnessed the rise of Dividend Growth Investing, or DGI. The underlying idea of DGI is to find companies paying a substantial and stable dividend that has a track record of growth and room to grow even more. Dividends are cash that a company decides to pay to shareholders. Dividends are usually paid periodically, but sometimes businesses will issue special dividends when the company coffers overflow. This cash usually comes from regular business operations, but in dire or special circumstances, a business may even borrow money in order to send cash to its shareholders: see oil companies from 2015-2017 and AAPL for examples, respectively.
Many American companies have a tradition of paying ever-increasing dividends. So common is the practice that lists have been established for the longest running, perpetually growing dividends: dividend “champions” and “aristocrats” comprise these vaunted rosters.
DGI practitioners pay close attention to a payout ratio, i.e. the % of net income that is used to pay a dividend. If a company makes $100 in a year and sends out $55 in dividends, then the company has a 55% payout ratio. A ratio that is too high can be a warning sign that the dividend may soon be cut or eliminated. DGI’ers also keep a close eye on debt and earnings trends. All this analysis is driven by the desire to see dividends not only continue to be delivered but also to grow annually at a rate greater than inflation.
One key tenant of dividend growth investing is that the value of an investment is equal to the risk-adjusted net present value of all future cash flows delivered to the investor. This definition of an investment is strong, as it follows from the concept of the time value of money.
We like the DGI approach because it encourages in-depth analysis, but we’re a bit wary of its popularity. In the current market environment, low-interest rates set by the Federal Reserve have driven investors to search for investments that pay a high % of cash back to the investor. DGI becoming mainstream has combined with this macro environment to push high-yielding stocks to historically high valuations. No matter how you determine to make your investments, buying at an exorbitant price is probably going to lead to disappointing results.
Pioneered by Benjamin Graham, value investing is a method designed to avoid overpriced investments and to lock in mispriced assets when they go on sale.
The key question in value investing is, “How much am I paying for profits?” The starting point for value investing is the P/E ratio, or price-to-earnings. Another way to think of this metric is the number of dollars that you have to pay to buy a dollar of annual profits. We can’t overemphasize that P/E is a starting point because the Earnings denominator can sometimes be out of whack. For example, if a company sells part of its business and receives a one-time cash infusion for this sale, Earnings can be extremely high making the P/E ratio look cheap on the surface, but this is just a one-time event. Likewise, a one-time charge to settle a lawsuit can make a profitable company appear to be losing money. It’s important to dig into the financial statements to calculate earnings going forward.
We’ve been finding that social media has provided us with investment opportunities by using tenants of value investing. The stock price of companies is subject to headline risk, meaning that a company may end up in the news and social media in a negative light. Stock prices are especially sensitive to sentiment on Twitter, and bad news can cause stocks to collapse too far to the downside. When we see viral negativity about profitable companies, we consider the event to be a trigger for more research.
Instead of focusing on the cost of profits, some investors dial into how quickly those profits are growing. Companies with a long runway to expand sales can be extremely profitable for investors, even if the profits come at a premium price. One might pay $17 for $1 of established blue chip profits (like Walmart), but may need to fork over $30 for $1 of profits that are growing aggressively (like Starbucks).
Companies can achieve growth through many avenues, including geographic expansion, new sales channels, expanding scale, selling internationally, participating in an expanding market, or grabbing market share from competitors. No matter the method, investors have done well by identifying growing profits that can be purchased for a reasonable price.
Our Approach: Timeless Earnings and a Long Runway
Overall, we seek to buy and hold ownership in businesses that produce products that are consumed repetitively and will always be needed. Couple these attributes with a strong brand, and a recipe for success begins to emerge. Our job as investors is to buy profits, and we’re looking to buy the best and most reliable profits. Perhaps more importantly, we’re looking to hold these cash generators for decades. Only by holding can one harness the power of compounding and time.
Avoid companies operating in disastrous industries
Banking, technology, mining: all three big red zones for us. A banking corporation is responsible for owning convoluted assets that sometimes go awry and sink the entire industry for years: see 2008. Technology companies must innovate at a breakneck rate, and misfiring during a product innovation cycle could all but extinguish a company: see Blackberry. Mining companies sell raw, unbranded materials that are indistinguishable between competitors: as such, they are forever chained to the macro swings of supply and demand and have proven to be a terrible place to invest money.
These are just a few examples of research we’ve done that has led to the conclusion: “Avoid that!” With so many investment opportunities, it’s important to say No to 99.99% of the options.
Find companies that operate in “timeless” industries
Consumer staples and healthcare will always, always be needed. Even if it becomes entirely outlawed, people will still drink booze. The modern world economy moves and shakes from the energy of petroleum products. In the long run, the lowest-cost retailer wins. These are some truisms that help guide us into the best investment selections.
Steer clear of companies that require massive regular reinvestment
Some companies must upgrade the core of their business regularly and at great cost. Cruise ship operators and cell phone carriers come to mind. Whether it’s the latest 8G super hi fi long range megacapacity mobile technology or the MS Grandoise of the High Waves, investing a few year’s profits into your company’s products is a surefire way to drag earnings down to nil. Compare this to the marginal cost of sending a few more Reese’s down the bought-and-paid-for conveyer belt.
Search for companies with a strong competitive advantage
This concept gets wrapped up and obfuscated under the buzzword “moat.” Most people equate it one-to-one with a brand, and brands are paramount, but establishing and maintaining a competitive advantage can be so much more. For example, running a business that has overwhelming start-up costs (e.g. mail order pharmacy) can provide some protection from disruption in one’s market share. Another incredible competitive advantage example is the ubiquity network effect enjoyed by Visa. It’s accepted just about everywhere, so just about everyone has a card. Try beating that with a “new way to pay!” – a pursuit that many companies have attempted and largely failed.
Overwhelmed? Keep it simple
In a “short” introductory article to investing, we’re easily eclipsing word count limits and have introduced dozens of concepts for further research. It’s easy to read this article and be unsure of how to proceed, but don’t fall into the trap of paralysis by analysis. Don’t overthink your investments. Go back to the heading, “How to invest with confidence” and read the paragraph where we recommend dollar-cost-averaging into an asset allocation of index funds. Start there. Stay there until you’ve taken the time to learn much more about the topic. When it comes to successful investing, you must act on two critical steps: #1 save up money, and #2 invest it. And you must act early – like now. Start investing now.
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