One of the most influential comments that has shaped my approach to investing came courtesy of Charlie Munger when he advised investors to "invert" problems by first identifying outcomes you do not desire, and then taking proactive steps to put yourself in a position to avoid those negative consequences.
Studies like those courtesy of Dalbar point out that typical investors only achieved returns of 3% annually when the S&P 500 increased by 7%. The Dalbar hypothesis was that this underperformance was attributed to investors selling low. To me, an easier way to avoid this potential problem is to only own assets I thoroughly understand enough to the point where I would regard a 40-60% drop as the opportunity of a lifetime, rather than something to mourn. In my case, that leads me to holdings in Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG), and Exxon Mobil (NYSE:XOM). If those three companies fell 40-60%, I would make extreme lifestyle changes so that I could add to my position in those three companies.
In my judgment, buying those three companies after a severe price decline would be a wise decision because they are excellent businesses that, based on present known risk factors, have the long-term earnings power to make investors that buy at a 40-60% discount very rich over the course of a 20+ year holding period. There is a Procter & Gamble product in 398 out of 400 American homes. Exxon Mobil generates over $35 billion in profit across 48 countries, and wields more power than the US embassy in certain energy rich nations. And Johnson & Johnson, even when it was coping with malfunctioning business operations during a severe recession, still managed to increase cash flow per share each year during the financial crisis (and has done this every year during the data I reviewed dating back to 1997). I would love to see these companies fall 50% without a commensurate decline in earnings power because that would be an excellent opportunity to purchase more.
When I construct my own portfolio, I find it useful to frame my portfolio additions through that lens: Which companies would I be overjoyed to see fall 50% or more? If you limit yourself to only owning companies that pass that test, you can eliminate a lot of potential misery from your life.
When a stock takes a 40-60% plunge, the payment of a dividend is usually the most tangible reminder that you are actually dealing with a real business, and a price decline does not automatically reflect a deterioration in the business, but rather, only reflects what someone else is willing to pay for a share at a given point in time (and there are numerous examples of when the stock market participants are irrational in either direction-should an intelligent investor have bought Microsoft (NASDAQ:MSFT) at over 50x earnings in the late 1990s? Should an intelligent investor have sold General Electric (NYSE:GE) at $6 per share during the financial crisis? Were those stock prices rational, or driven by emotion? Since I don't believe that GE's intrinsic value has tripled in the past four years, I vote the latter).
Considering that P&G and J&J have been paying out growing dividends for 50+ years, and considering that Exxon has been paying out a dividend dating back to the 1800s if you trace its origins back to Standard Oil, it is likely that an income focused investor could easily ride out an economic storm by owning these types of companies that have records of rewarding shareholders even under hellish economic scenarios.
Almost all misery in the stock market for income investors could be avoided if you:
- Limit your exposure to the financial industry to 10% or below.
- Own companies that have been raising dividends for 20+ years.
- At the time of purchase, own companies that have been growing earnings and dividends by 5% annually for the past decade.
- Diversify into 20+ holdings across 6+ sectors that share those characteristics (20+ years of dividend growth, and ten year track records of at least 5% earnings and dividend growth) with limited exposure to the financial sector.
If someone promised me $1 million if I could construct a portfolio that would go bankrupt within thirty years and I had to evenly split the money into twenty piles of 5% each that only consisted of non-financial companies that had been raising dividends for 20+ years and had grown earnings and dividends by at least 5% annually from 2003-2013, I don't think I could do it. Combining those three characteristics would be too powerful even if I tried to fail.
Each of those four characteristics brings something powerful to the table that, when combined, can create a fortress like portfolio. If you limit your exposure to financial stocks to 10% or less, you are isolated from the effects of management that can destroy great things quickly due to the nation of high debt to equity businesses. When you own companies that have been raising dividends for 20+ years, you can find companies with strong business models because, as the saying goes, "you can't fake a dividend payment." When you demand a track record of 5% earnings and dividend growth, you are filtering through companies that increased rewards to shareholders throughout the worst of the recession in 2008-2009. And when you diversify into 20+ companies, you are guarding against fluke events like a BP (NYSE:BP) oil spill or a Fed-mandated dividend cut like we saw at Wells Fargo (NYSE:WFC). That's my four-step prescription for building a portfolio that could withstand just about anything.