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American cartoonist Rube Goldberg (1883 to 1970) was famous for his illustrations of overly engineered machines designed to perform relatively simple tasks. More often than not, today’s investment products are akin to his “self-operating napkin” illustrated above. But when it comes to investing, we do not believe that complexity yields better results than simplicity.
At the most fundamental level, we invest in businesses for our clients. The shares of each stock that we purchase represent small ownership stakes in large companies. Folks will often dispute this fundamental truth and instead “play the market” like the roulette wheel at a Las Vegas casino. But at a casino the house profits while the naïve fall flat.
To the contrary, this gambling concept only applies to stock investing if investors take the wrong approach. Let us consider the right approach to buying companies.
Although it is seemingly a cliché, a long-term mindset is paramount. Think about a successful small business owner that you know and ask yourself whether the owner started or bought the business with the intent to sell the company in a day, a month, or even a year. The very idea is ridiculous. Instead, the entrepreneur is committed to the business for many years, even decades. True stock investing should be no different because, over the long-term, history shows that a company’s stock price will almost always track its earnings growth.
The inherent problem with stocks is that the market prices them on a second-by-second basis. To ignore this manic pricing is one of the disciplines of investing.
If the busiest and most profitable restaurant in town was valued minute-to-minute, what do you think would happen to its price when a blizzard blows into town? What would the talking heads on CNBC declare if a talented sous chef quits? But in reality, neither of these events fundamentally changes the value of the town’s best restaurant.
A long time frame can compensate for unpredictable events that bear on day-to-day pricing, but even the long-term is not foolproof.
The purchase price of a business also matters. If you pay too much for the neighborhood Laundromat, it is likely that no amount of management savvy or entrepreneurial ingenuity will save you. After all, there is a limited quantity of washers and dryers in the building and a finite number of hours in the day.
The good news, we do not need to buy stocks when we cannot find a company selling at an appealing price, just as an experienced landlord can delay acquiring a new apartment complex if the appropriate return on investment is not available.
For diversification reasons, we do not limit our portfolio to just one or two companies. Rather, we build a collection of businesses. The term diversification is another example of over-used investment jargon. The purpose of diversification is simply to spread risk among a variety of enterprises.
Only the wealthiest investors could own the aforementioned restaurant, Laundromat, apartment complex plus twenty other varying businesses in their community. It would require an enormous amount of capital. But, with stock investments you can diversify among businesses of all different stripes and also obtain global geographic exposure.
This is not to say that one cannot make fundamentally bad decisions. For example, five years ago an entrepreneur would have wanted to avoid buying a DVD rental store because of the imminent impact of on-demand, Netflix, and Redbox. Diversification, though, does mitigate the damage of an individual miscalculation.
Even with adequate diversification, it is necessary to understand that being a business owner is inherently risky. There is no such thing as a riskless business. For many years, General Motors franchisees in communities all across America may have thought they had a virtually bulletproof proposition. But, Honda, Toyota and the Great Recession changed all of that.
So, in addition to being diversified, remaining price-conscious and thinking long-term, investors need to make personal decisions about how much they should allocate to risky assets. Do not be fooled like many were in 2008 and believe that combinations of risky assets magically produce a riskless portfolio. Now, more than ever, as the result of globalization, risk-based assets will continue to move with extreme correlation in the event of a crisis.
Therefore, investors should determine how much of their assets they will commit to low risk fixed income. Matching relatively safe bonds according to anticipated cash flow needs and holding each bond to maturity is an optimal strategy. In our present extreme environment of low interest rates, we view bond mutual funds as inherently risky and unlikely to provide the stability that many are anticipating.
15th Century Renaissance man Leonardo da Vinci once said, “Simplicity is the ultimate sophistication.” When building portfolios, we adhere to da Vinci’s words of wisdom by creating a mix of strong businesses and safe assets that meet the individual goals of our clients.
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Our investment approach is straightforward, transparent, low-cost, tax-efficient and independent. We invite you to work with us.