Economics Professor Joe Taffet was part of my upbringing. Joe taught “Money and Banking” and “Stocks and Bonds” at City College in New York, where he was known as much for his humor as for his scholarship. Whenever the subject of investing came up, people would ask Joe for his advice. His advice never varied: “Buy low, sell high.” Usually this elicited a twitter or a guffaw. But Professor Joe was right, not just amusing. If you are an individual investor who invests in individual stocks rather than through mutual funds, buying low and selling high has to be what you are after, and you never should take your eye off that ball.
Even if you like dividends, buying low and selling high is paramount because if you get a 4% dividend and the stock loses 10% of its value, your supposed 4% income was illusory—you were just living off your capital. Total return is the only real deal. Yes, high dividends tend to support a stock price, but a dividend cut can be lethal, as stockholders of companies like Bank of America Corp. (BAC) know too well.
The Total Portfolio Approach
These days, I live mostly off my investments. And what matters is the relationship between the value of my total portfolio, net of what I have spent, at the end of the year (or other period) compared with the end of the prior year. Whether my gains consisted of dividends or interest or capital gains or unrealized gains is important only for tax purposes, and taxes I paid will be factored into my computation automatically because they will appear as withdrawals from the portfolio (admittedly, slightly in arrears). This total portfolio approach tells me graphically when I am living beyond my earnings.
Once you decide to see your investments this way, on a net gain-or-loss, total portfolio basis, you can become free to pursue buying low and selling high. You free yourself from benchmarks and become free to “seek alpha”. Now you can select sectors based on how you see macroeconomic factors, future technologies, and demography to maximize your possibilities of selecting companies that will perform well. Now you can select companies based on careful research about their likely earnings performance compared with their current share prices. Now you can decide to change your percentages of portfolio invested in stocks, bonds and cash, not based on a formula but based on your evaluation of the markets. When stocks are high, you can sell, and when stocks are low, you can buy. You can treat cash and bonds interchangeably based on risk/return rather than on an idea of what you need to earn in interest or dividends to support yourself.
Macro Forces Matter
This way of looking at your investments takes advantage of the fact that most investments are highly correlated. Diversification can help you only so much, since in recent years—and probably in the future—stock averages—even internationally—have tended to move in the same direction. This means that a good investor spends much more time than usually has been recommended studying the macro factors—indeed, studying the global macro factors. This is because allocation between stocks and cash is so important to the portfolio’s returns. (High-rated bonds are little different from cash when interest rates are low, and low-rated bonds should be seen like stocks—dependent on performance of the economy.)
Changing allocations in accordance with macro factors used to be decried as “market timing”, and it was said that one could not time markets. But it is not true that one cannot time markets. One is unlikely to time markets precisely, but one does not have to do that to succeed. One only has to be long stocks during periods of market rises and not as long stocks in periods of market declines. If you move 25% of your portfolio from stocks to cash while the market is declining, then increase your holding of stocks by that 25% near the start of a market resurgence, then you can be way ahead of most investors, will make money in most climates, and will make a lot more money over the long term.
Where are we today? Is this a time to be “all in”? All out? Unfortunately, I do not know. I think 2012 will not be a bad year for stocks. But I am not sure. Therefore I am mostly invested in stocks but hedging my bets, leaving some cash on the sidelines to invest at the right time, but protecting myself on the upside as well. Big opportunities come along only after big market swings, one way or the other, and 2011 did not provide any extremes.
Markets overshoot. That is their nature. And we should be all in or all out only when it is fairly clear that we are at or near such a time. October 2007 was an obvious high—selling was called for. February 2009 was an obvious low. Going all in was called for. 2003 was a great year. And you could see it coming—maybe not right then, but soon. Most times are in between, when you have to be good at picking stocks and sectors.
From the losses I, like most investors, incurred in 2008, I learned to respect the macroeconomic downside even more than I had. I also learned that I had to pay more attention to the macro factors affecting each business. Few companies were able to paddle uphill against the flood of bad macroeconomic news in 2008. But some sectors could do better than others. Low leverage was a key; companies with low leverage could live to fight another day; and some sectors naturally are less leveraged than others, such as most of the oil companies and technology companies. It did not matter whether companies were small cap or large cap—good balance sheets mattered, especially for companies that went through a year or two of losses. Companies in the medical field also outperformed because they continued to get paid by insurers, and the demand for health care was relatively inelastic.
Challenge Yourself to Reevaluate Every Stock You Own
I am now in the process of evaluating what kinds of businesses are going to flourish in 2012 through 2014. I will be ruthless with myself psychologically to weed out companies in my portfolio that do not match up. And I will start afresh with my portfolio over the next few months. I will do this because I know that Professor Joe was right: Buy low, sell high.
Here are a few of the things I am looking at:
- We know from demographics that, globally, more people are going to be buying cars, washing machines, refrigerators and other middle class goods. What companies are postured to benefit? If they are not American or European companies, how can I evaluate them and how can I buy them? Buying developing market stocks is quite different from buying American or European stocks. In the past, I have been reluctant to buy individual Chinese or Indian stocks and have invested in those markets through mutual funds (such as CHN, TDF, IIF and IFN, adjusting volumes based on my evaluation of market prices). I am wondering whether I should overcome my fears about developing legal systems and unknown standards of accounting and disclosure. I remain biased toward buying companies whose disclosure regimes I think I understand better.
- We know that globally more people are going to be demanding sophisticated medical care. But we also know that other countries are unlikely to copy the American model of high choice, high cost. What companies have the right business models to profit within the efficiency demands of the developing world? I do not think it will be Big Pharma.
- We know that IT and other technologies are going to continue to replace workers. And we know that this trend will accelerate as Chinese and Indian workers earn more, since replacing them will become more worthwhile. What companies will pioneer and profit from this replacement process?
- We know that the cost of communication will continue to get closer to zero. I will stay away from legacy companies that are doomed, like Verizon (VZ) and AT&T (T). But what companies will benefit? Will companies like Cisco (CSCO) continue to flourish by becoming more efficient themselves? Passenger railroads did not make money for a long time, but some of their suppliers did very well. Or will I have to take more apparent risk by investing in smaller, less proven companies?
- Incomes throughout the world are not likely to become more equal. What are the best stocks to take advantage of the spending power of the rich? And what should I do if those stocks are over-priced, as many of them are? I looked at buying more Coach (COH) and got scared off by the high ratios—price-to-earnings, price-to-book, price-to-sales. Again, do I have to look for less proven companies? Probably so. But those companies are most likely not going to be American, and I will be faced with the question of how to evaluate developing economy stocks.
Where might you find some additional big questions to ask yourself? Try, for example, the McKinsey Quarterly. It provides excellent insights about global trends.
As I go through my evaluation process, if I get insights that I think are worth sharing, I will write about them here. And by the way, the buy-low, sell-high goal is not for the faint of heart. If you are not prepared to suck it up when times are hard, you had better try some other investment methodology.