My Investing Objective
My objective in investing is to double my portfolio value every 5 years. Essentially, this means a 100% return on my investment every 5 years. What does this mean in practice?
Payback period of 5 years: It means getting a payback on my investment every 5 years. If I invested $1000 today, I hope to receive back $1000 over the next 5 years, excluding my capital. My payback period is 5 years for the investment.
Return of Investment of 100%: Another way is saying my return on investment over 5 years is 100%. This means at the 5th year, my investment of $1000 should have grown to $2000. This will give a return of investment of 100% over 5 years or a return on investment of 20% per year in simple average terms.
Discount cash flow method (CAGR of 15%): I can also use the discount cash flow method too. For my initial investment of $1000 to grow to $2000, what is the compound annual growth rate required to achieve this return? Alternatively, working backwards, if the expected final value of the portfolio at the 5th year is $2,000, what is the discount rate that will give a Net Present Value of $1,000 (the initial investment amount)? The answer to both questions is about 15% per year.
What is the average return of the stock market annually for the historical long term basis?
It is about 10.5% annually. If one invests into the stock market for the long term, one can expect to compound at an annual return of 10.5% over the long term.
However, this market return is a highly volatile one, especially for those with a short investing time horizon. In a 1-year investment time horizon, the return of the market can be an upside of 50% or the downside equivalent of 1/3rd. That is, your portfolio value of $1000 can gain $500 (giving you a final portfolio value of $1500) over 1 year or your $1500 portfolio value can lose $500 (giving a final portfolio value of $1000) over 1 year.
However, if your investment time horizon is 10-years or more rolling, the market volatility is less and you can expect no losses. Over a 10-years time horizon, the returns of the market are as depicted in the chart below, ranging from a high of 19.4% to a low of 1.2% , with the average at 10.5%. Over a 25-years time horizon, the returns of the market are between the high of 17.2% and the low of 7.9%, with the average at 10.5%.
Two Prongs Approach
How to achieve the 100% increase in portfolio value over 5 years?
For this, a two prongs approach is employed.
- (A) Stock selection is an important part of this.
- (B) The other equally important, is portfolio management.
How can one achieve a compound annual return of 15% per year or an annual return of 20% per year in simple average terms for periods of 5 years running in stock market investments?
What strategies should be employed to achieve the 100% returns on your investment every 5 years, consistently and safely (without taking excessive risk, that is, low risk and high return situations)?
A. Stock Selection
1. Asset allocation
Asset allocation is important. If you allocate 100% of your investment into fixed incomes (like bonds or fixed deposits), you are unlikely to achieve this 15% compound annual return over 5 years. These fixed income products protect your capital (but not against inflation over the long run) but their returns are too small to achieve your objective.
You have little choice but to allocate your asset into products that can give you higher returns over time. I suggest an asset allocation of 40% Equity and 60% Fixed Income Products for those who are conservative and loss adverse. For those who are super-conservative, maybe in the early learning stages of their investing or those in retirement, a 20% Equity and 80% Fixed Income Product portfolio can be employed. For super-investors, the like of Warren Buffett, who knows what they are investing, the asset allocations are little in cash/ cash equivalent/ fixed income products and mostly into equity. Buffett keeps enough cash to take advantage of opportunities that can present unexpectly at any time.
2. Fixed Income Products
This have been mentioned above (1). These include your fixed deposits and bonds. Preferred shares are included here too.
3. Blue chips bought at reasonable prices
These are companies that have done well over a long period. They are profitable and their businesses are predictable. They also give regular dividends. They are generally matured companies that have captured their share of their business in their market sector. They do grow, though slowly when compared to their early days or to the smaller successful companies. Most of these companies grow at single digit growth rates. Their business revenues per year generally exceed $5 billion or more.
You should choose one that has a minimum growth rate of 7%, preferably more. Since most of these companies do give dividends (generally the dividend payout ratio in these companies are high), you can look for dividend yields of between 2.5% to 3.5%., averagely 3% or more. Adding these two figures still fall short of your expected returns of 15% per year. Yes, and if you re-invest your dividends (not necessarily into the same companies that give them), you can achieve this compound annual return of 15%. In general, you can expect 50% of the total returns from these investments to be from the dividends and the rest from capital appreciation. Don't ignore the impact of dividends on your total return, this can be significant indeed.
What other further strategies can one employ to achieve the compound annual return of 15% or more, doubling your portfolio value every 5 years?
4. Buying blue chips at bargain prices during a market downturn or when the market is obviously low
The stock market prices are influenced by market sentiments. There are periods when the market players are very pessimistic about the market. During these times, good stocks are also sold down and their low prices in the market are unrelated to their business fundamentals.
Provided you as an investor can be disciplined and rational in your approach and know the difference between price and value, you are presented with this opportunity to buy good and great blue chips at bargain prices. The lower the price you pay to own these companies, the higher you can expect your returns to be. Yes, certainly buying these blue chips during market downturn will reward the smart or aggressive intelligent investor with higher returns, and deliver to them the compound annual return of 15% or more per year which they are seeking in their investing.
5. Buying growth stocks at reasonable prices. (Growth Investing)
These are companies that are growing their businesses very fast (>15% per year or more). Where can you find them?
A small startup company in the early stages without profits to show and sucking in a lot of capital is full of risk and with unpredictable future returns. Those who invest in these should know the business well and be willing to take the risks. They should be prepared to lose 100% of their money if things do not play out well. Investing in these start-ups is speculation. We shall focus on investing.
A successful startup will soon enter an explosive growth phase. The growth can be very fast indeed (perhaps growing between 40% to 30% annually). In the very early stages of this rapid growth, they absorb a lot of capital to support their fast growth. Though profitable, they retain all the earnings and often need to sought new equity capital and also debt to grow their businesses.
This explosive growth phase will eventually attenuates. They are still growing at a rapid pace, between 20% to 15%. By this stage, these companies are profitable and generating positive (and hopefully growing) free cash flows. They retain a portion of their earnings for growth and are now able to distribute some or more of their earnings as dividends. In general, look for those companies distributing 30% to 70% of their earnings as dividends and are still growing rapidly between 20% to 15% per year.
For those whose objective is to achieve a compound annual return of 15% per year or more and doubling their portfolio value every 5 years, focusing their effort in this segment will be most appropriate and rewarding. These are the small-cap and mid-cap companies in the stock market. Always ensure that their businesses have economic moats that are deep and wide (these confer them their durable competitive advantage) Many of these companies have business revenues less than $500 million per year (small businesses). There are also companies with business revenues between $500 million per year and $5 billion per year (middle sized companies).
6. Buying undervalued companies (Value Investing)
You can adopt the strategies of the bargain hunters (the value investors of Benjamin Graham). Benjamin Graham uses the simple comparison of price versus the book value and buy with a margin of safety of 30% or 50% discount to the book value. However, he also uses other criteria in his selection too (look these up).
When do bargains appear?
An obvious time, is during period of pessimism. Think John Templeton. "Buy your stocks during periods of maximum pessimism. " The general market is sold down and you can expect to find more bargains during this time than during the period when the market is in an exuberant mood.
As for specific stocks, there are also times when the market may view these stocks very unfavourably. The company may have run into difficulties during that period. The fundamentals of the company maybe temporarily or permanently impaired. There maybe some fraud discovered. The company may have made an acquisition which is perceived negatively. The company's product may be in the news for the wrong reasons. There are so many reasons that can cause the company to be in the news for the wrong reasons.
To profit from these, the investor needs to assess the congruence between the news and the price. Maybe the company is punished appropriately, and the price is reflecting its value. On the other hand, the company maybe punished inappropriately and the price is too low relative to its given intrinsic value. Here lies your opportunity to capture the gains offered by this bargain, should you be proven right and the other investors re-priced this company to its appropriate price. A margin of safety of 30% gives you an upside potential gain of 50% and a margin of safety of 50% gives you an upside potential gain of 100% when repricing occurs.
I personally, feel it is more challenging to be a value investor than a growth investor. You have to be right about the company that has recently fallen from grace. You have to be right and others are wrong to profit from this opportunity. What if, you are wrong and the others are right? Also, it may take a very long time for the market to reprice your stock, even though you are right. The longer the time for this repricing to occur, the lower is your annualised return. These stocks generally need to be sold once their prices approached their intrinsic value. You need to sell them at the right time too to capture the maximum potential gains. All these difficulties are not faced by the growth investors who bought their high quality growth stocks at reasonable prices, and holding them for the long term, if not forever.
In the above paragraph, my thinking is guided by this quote from Warren Buffett:
"It is better to pay a little too much for something that is a very good business than it is to buy some bargain but really a company without much of a future."
All the above strategies can be employed regularly in the market.
There are also various strategies that can be employed to achieve 15% per year return over the long term to grow your portfolio value 100% over the period. However, these are infrequent and often less accessible to me as a lay-person investor. Among these are:
7. Purchasing well-secured privileged senior issues (bonds and preferred shares) offered at bargain prices.
8. Purchasing in special situations which you have good knowledge of: Mergers, arbitrages and cash pay-out.
I strongly believe that the paths below will not help me in my objective to grow my portfolio value 100% over 5 years with the degree of certainty that I want. Accordingly, they are speculations which I would avoid. These are:
A. Avoid buying IPO. "Its probably overpriced"!
B. Avoid trading in the market. This is a negative sum game in my book. Those who indulge in this, as a group or aggregate, will generally lose money over the long term.
C. Avoid buying growth stocks at high prices. Growth stocks are liked by many and often maybe trading at high prices. It hurts your portfolio if you pay a rosy price to acquire these stocks especially when they are popular and in the news. "You can never get a bargain on a stock that is popular." Be patient and disciplined, you will have the opportunity to acquire the same stock at a better price.
B. Portfolio Management
This is equally important and contributes to achieving your investment objective of doubling your portfolio value every 5 years.
Maintaining a concentrated portfolio of stocks
I maintain a concentrated portfolio of about 10 carefully chosen stocks. The turnover of this portfolio is generally very low indeed, reflecting the nature of the stocks selected. I am not in a hurry to churn the stocks in my portfolio to grow my net worth quickly, as compounding over the long term at 15% per year translates into very big incremental absolute returns in the later part of the long period of my investing time horizon.
Having a few stocks allow me to focus and monitor the businesses of these companies more closely. It also gives me the courage to put in large amounts of money into each of these stocks in my investing.
Why 10 stocks? I will just invest in the best stocks that give the most upside to downside reward to risk ratio and potential high returns. Over diversifying into too many stocks will give one the market returns, thus, maybe diluting your potential returns that can be derived from this strategy.
As there are only 10 stocks, each stock will have a potential value weighting of 10%. Meaningful investing means investing at least 3% of the total portfolio value into each stock. Too small an investment into a stock is meaningless as even a 100% gain in the stock contributes to an insignificant gain to the whole portfolio value.
Do I sell when a particular stock is proportionally too high in value in my portfolio? Not really, unless for good reasons (see below for, when to sell). In my portfolio, a particular stock has at one stage a 30% value of my whole portfolio and it was still undervalued. I am willing to ride my good fortune or accept the risk of a over-represented good quality undervalued stock in my portfolio.
There are many benefits from having a long term successful portfolio. It allows you to capture the capital appreciations and the dividends of the portfolio over a long time. The dividends of the portfolio is a big amount and this attenuates the fluctuating returns of the portfolio in a bear market. Compare to traders who bet a certain amount and made a 100% gain, their gains probably paled to insignificant to the dividends of a successful long term portfolio. The dividends annually dwarf the gain of any single successful trade of a frequent trader.
When to sell
As mentioned, these stocks are rarely sold. However, there are occasions when selling is needed.
A stock will be sold if its fundamentals have deteriorated permanently and the management is unlikely to turn it around anytime soon, example, in a year. This stock should be sold quickly and the action requires one's urgent attention. To not do so may cause financial harm to your portfolio. On certain occasions, for example, fraudulent accounting, one should just sell first and think later.
Selling an overpriced stock is also a good portfolio management move. The price is already too high and its upside potential maybe little or none and you are only facing its downside risk of loss, while invested in this stock. You should sell partially or totally, and replace this stock with another with an equal or a better quality and with a better upside reward to downside loss ratio and potential higher returns. This improves the quality and the potential returns of your portfolio. This will ensure that you can achieve your 15% compound annual return in your portfolio value, doubling the value in 5 years.
On certain occasions, you may have identified a very good stock to invest into that is severely undervalued. It is of high quality and the upside reward to downside loss ratio is very much in your favour. It is selling very cheaply and your potential future return is going to be very very high. You have great confidence in your stock pick and wish to put a lot more money to ride on this big bet that has presented itself. You may then sell some of your existing stocks with still good upside to downside ratio to reinvest the money into this new stock with better upside to downside ratio and potential higher return. Again, this will ensure that you are always improving the quality and returns of your portfolio.
Cash is also considered an asset class in the portfolio. Where the market is so overpriced and you cannot find a stock that provides safety of capital and promises of a satisfactory return better than cash, building up a cash reserve is appropriate for that period. The time when I was in 100% cash (or 0% equity) has never happened before and this should be a very unlikely event. This probably can only happen in markets as was in 1996 or 1997 when the market was bubbly and irrational; even then, I was not 100% in cash then.
Confronting a Bear Market or severe Market Decline
Market price is volatile. That is certain. Also, a good quality growth stock over the long term should build its intrinsic value. That is also certain to a high degree of probability.
Should I be in 100% cash when the market is a bubble in exuberant territory? Should I sell before or when the market crashes? Do I have the uncanny ability to time the market in these periods?
In general, it is very difficult to know if the market is fairly valued, overvalued or undervalued most of the time. There are a few instances when you might know that the market is obviously too overvalued or too undervalued, however, these are extreme circumstances and rare events (example, in 1996/97 when it was obviously overvalued, in 1998 when KLCI was 300 points when it was obviously severely undervalued, and in Sept 2008 the Lehman crisis, when the market was severely undervalued and at the capitulation point.)
However, for one who is invested into individual stocks, these market fluctuations are meaningful to the extent that in a low market you have the chance to buy the stocks cheap and in a high market you have chance to sell the stocks at high prices. You can adopt this strategy of pricing the market, that is, buy low and sell high. Equally productive and less taxing on your skill, is just buy low and do not sell; and of course, do not buy high. The latter too is an effective strategy, especially since you are buying and holding only good quality growth stocks with durable competitive advantage. You are betting on and aiming to capture the fantastic earning powers of your invested companies over the long term of 5, 10 or more years.
Even if the market is overvalued, you can sometimes still buy undervalued stocks. Of course, during this time, there are less of these undervalued stocks in the market.
Do you sell ahead of the falling market? Only if you have the ability to know this with certainty. Can you do so consistently? Of course not. A reasonable strategy is to make as much money as you can in any market, whether it is trending up or down. Also, be prepared for the appearance of the bear when you are in the bull market period. When the bear does appear, be prepared to see your portfolio value going down even 50% from its peak. (For this reason, do not buy stocks on margins. You never know when a bear market may appear decimating your net worth due to your leverage.) Your consolation is you will have so much gains already in your long term portfolio, this 50% decline in portfolio value does not cause the loss of your initial capital. However, your portfolio intrinsic value is definitely worth more than the market value of your portfolio in a bear market which is determined by the emotional market low prices of the period. You can still sleep well and actually take advantage of the bear market to buy good quality growth stocks that are now offered at ridiculous bargain prices. When the market normalises, as it should, you are once again, a winner.
The biggest threat to your portfolio - YOURSELF
The biggest threat to your portfolio value is actually yourself. With the right knowledge and skill, you can invest safely and profit from the market over the long term. The long period of compounding will certainly make you very rich indeed.
The above are my philosophy and strategies to grow my portfolio at a compound annual return of 15% per year, doubling my portfolio value 100% over 5 years.
Look at the single chart above that depicts market returns. Over the 25 year long term investing horizon, the stock market has returned between 17% and 8% annually, averaging 10.5%. By employing the strategies above, I have chosen to capture the gains offered by the top half of this range, that is, between 10.5% to 17%. With dividends reinvested, this 15% compound annual return is achievable.
Of course, Benjamin Graham has counselled, "It is not difficult for the intelligent investor to achieve modest returns (to get market return, use low cost market index funds) but when they aim for better returns, they might find that rather than getting better results, they might in fact fair worse than the average."
Those who are defensive investors should just stay with a simple asset allocation of fixed income (2) and blue chips (3) above.# Those who are willing to put in the diligent effort, should still stay with an asset allocation of fixed income (2) and blue chips (3) and they can include into their investing all the others mentioned (4, 5, 6 & 7).
Be reminded to always stay within one's circle of competence. You should be able to define the boundary of this circle and never stray out of it.
Finally, should a "big fat pitch" opportunity that is within your circle of competence appears, you should have the cash and the courage to take advantage of it. I believe you can with the right preparation, philosophy and strategy.
May your investing be as successful, with a bit of good luck thrown in.
#(P/S: For those who are not comfortable choosing their own stocks, they should choose a low cost index linked fund for the equity portion of their asset allocation.)