Risk and Benchmarking

Risk and Benchmarking 150 150 JP

Even the best investors on the planet lose money on certain assets, regardless of how intelligent or risk averse. Don’t make the mistake of trying to be perfect. The best way to limit risk in the stock market is to invest in businesses that are going to withstand the test of time. These are typically profitable and growing and bought at the lowest price multiple possible. Then diversify into as many of these stocks as you can find, and plan on holding them for the long-term.

If you’re not outperforming the S&P 500 Index over a 5 or 10 year period, you should place the majority of your assets into an Index Fund, and speculating on trades with far less capital. Again, there’s nothing wrong with trying to find the next Facebook or Priceline before they turn profitable, but while you do it, make sure you’re building wealth with the market too.

Shareholder Equity

Shareholder Equity 150 150 JP

Shareholder equity is the difference between total assets and total liabilities. On a per share basis its known as book value. Companies that translate retained earnings to equity growth become more valuable. It is worth noting that legendary investor Warren Buffett has used book value to benchmark the value of his conglomerate Berkshire Hathaway for over 40 years.

Book value is a historic number, providing no information about the future prospects of a business, apart from demonstrating consistency. However, if every dollar in retained earnings can generate at least the same in market value, then the company has added value to shareholders. That’s why return on equity is such an important ratio to top value investors.

Even though Apple and Amazon are valued differently by the market, investors cannot overlook the ability of both companies to grow book value. No matter what strategy you follow, being able to find stocks attached to companies that can do this will virtually guarantee you make money in the market.

Apple (AAPL)

book value
2009: $5.02
2012: $16.99
2015: $22.53
2018: $25.81

stock price
2009: $13.74
2012: $59.79
2015: $111.44
2018: $169.23

Amazon (AMZN)

book value
2009: $6.23
2012: $18.04
2015: $26.39
2018: 64.84

stock price
2009: $55.74
2012: $175.17
2015: $314.75
2018: $1,169.47

Analyzing both book value and earnings per share, investors can estimate the future value of almost any stock. Companies that have built brand power and strong competitive advantages tend to last longer.

Payback Theory

Payback Theory 150 150 JP

Let’s say you live in a town with two bakeries for sale at $1 million each. Both offer similar products with almost exactly the same type of customer and asset structure — one earns $100,000, the other $150,000.

Which one do you buy?

The one that makes more money! That one has the highest yield, which in this case is the second bakery. In fact, if these numbers held up, bakery number two would pay you back in less than 7 years, a full 3 years ahead of the first one.

To know whether an asset is worth buying, you have to know the profit it generates compared to the price you’re paying, otherwise you’re simply speculating on whether or not you can sell it at a later date for a higher price. Not all art or Jordan sneakers fetch higher prices.

For example, if you buy a house for $500,000 and lease it for $2,500 a month, the annual yield before expenses is 6%. For private businesses its the profit for the price you paid. However, in the public markets, companies listed on big exchanges like the NYSE or NASDAQ tend to remain in business a lot longer and are thus valued at higher multiples of earnings. This means looking for growth potential at a fair or discounted market price.

Very rarely will investors acquire shares in an excellent growth company at current high yield prices. These companies must grow into the high yield prices.

Apple (AAPL)

Value: $76 billion
Profit: $6.1 billion
Yield: 8.0%

Apple (AAPL)

Value: $1.01 trillion
Profit: $56 billion
Yield: 73.9% on 2008

Investing Strategy

Investing Strategy 150 150 JP

In the next two decades, barring major advances in life extending technology, the wealthiest generation (aka Baby Boomers) will pass down close to $30 Trillion worth of assets to their children and grandchildren. That money has to go somewhere. To me, it’s not a question of what asset should investors buy because it’s only a race between stocks or real estate. There’s no third place asset in this race. Bonds, Savings/CD’s, and Gold will all fall well short of these two, which is why you do both — buy real estate and stocks.

If you’re happy with 7-8% a year, then you should buy an index fund like VOO, SPY, or FUSVX whenever you have additional cash to invest. Putting your money into a fund like this over regularly scheduled intervals will likely outpace 90% of investors during your lifetime. If you want to do your own homework, The Little Blue Book by Joel Greenblatt is a great starting point. Or, if you can handle more complex reading, Ben Graham’s Intelligent Investor or Warren Buffett’s collection of shareholder letters are fantastic. Each of these money managers produced market beating results for decades. My goal has always been to model and refine the best strategies to produce similar or better results.

That said, picking the right stocks is hard. It’s right up there with being a successful entrepreneur because it requires consistency and patience. Very few are going to be as good as Buffett or Icahn, which is why buying an index fund is becoming even more popular, along with services like WealthFront or Acorns. Obviously, my opinion is that buying stocks create the best opportunity to build wealth with the least amount of risk, but after 15 years in the financial markets, managing money and publishing research, the biggest hurdle that’s still prevalent today are the fees.

Regardless of what asset type you’re purchasing, here are three questions that can lead to better investment decisions.

#1 What is the future estimated value of the asset?

This involves looking at historical data to analyze financial metrics, growth rates, and price multiples estimating value based on past performance, current comps, and future potential. As with most assets, the more unique the more valuable and use a different set of core tenets to estimate value to price for each opportunity. Value estimates are determined in a variety of ways depending on asset class, but with most investments it comes down to the amount of cash that can be produced over the remaining life of the asset, then judge that figure against the price paid today.

#2 Can the asset’s value grow faster than the S&P 500?

With dividends the Standard and Poor’s index of 500 large publicly traded companies has produced an average of 10% a year for nearly five decades. An investment is one that beats inflation first, the market second. It’s rather easy for investors to buy an index fund and simply plug money in anytime he or she would like. Doing this will outperform inflation as well as the majority of their peers and professionals alike.

#3 What is the time frame for your investment?

For short-term trades like options, arbitrage, business/real estate flips, it’s important to know the time horizon. A 5% gain every 45 days turns into a 47% pre-tax return. For long-term investments, there might be months or years of flat to negative growth before seeing a massive return. What matters is that your money out brings back at least 1.15x money in every year, judged over a 3 to 5 year period. Even though the broad market may have periods of higher than average gains, normalized returns tend to be right under double digits for the stock market. And, as economies mature, count on lower returns.