Buffettisms To Focus Your Investment Strategy

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 |  Includes: JNJ, KO, MCD, PEP, PG
by: Eli Inkrot

If had to pick 5 companies that I would invest in forever-- companies that I would buy today and never sell a single share of-- I would choose Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG), Johnson & Johnson (NYSE:JNJ), PepsiCo (NYSE:PEP) and McDonald's (NYSE:MCD). Obviously my investing universe isn't limited to just these 5 equity selections. I have literally thousands upon thousands of different possibilities and combinations available to me. I could buy any number of individuals stocks, ETFs or Mutual Funds. Moreover, one's investing decisions need not be strictly limited to just equity opportunities. In fact, it is fundamental to consider every applicable alternative that you might be able to use the money for.

But that doesn't mean that the exercise doesn't carry weight. Take a moment and consider the 5 companies that you would be most likely to hold forever. While it is probable (and advisable) that you will stake an ownership claim to many more than just these 5 companies, it is at least reasonable that your core holdings will reflect these 5 businesses precisely; whether by direct ownership or by a group of holdings with similar characteristics.

I chose KO, PG, JNJ, PEP and MCD for their excessively powerful brands, pricing power, consistency and overall inclination to continuously reward shareholders namely through constantly increasing their dividends at a rate that far outpaces inflation. It is important to establish the fundamentals of your investing strategy. If you do not understand why you invest in something you cannot develop rational expectations. To help us in this endeavor, Warren Buffett has graciously offered the following guidance:

"Never invest in a business you cannot understand."

I understand that Coca-Cola will sell 1.8 billion servings of beverage today. Procter & Gamble will entice some buyers with its Gillette, Tide, Crest and Bounty names. Johnson & Johnson will stick to the healthcare basics of Band-Aids, Tylenol and Listerine. Sure PepsiCo will play second fiddle to Coca-Cola in beverages, but PEP will certainly take the lead with its salty snacks like Doritos, Cheetos, Ruffles, Tostitos and Lays. Finally, I know that McDonald's will serve 68 million people today in any one of its 33,000 restaurants. It's not particularly difficult to determine why these types of companies make money. Millions (or Billions) of people demand these products and are willing to pay a premium for it.

Let's say that instead of investing in a collection of your favorite companies you just go with an S&P 500 ETF Index, the SPY for example. Now you hold a portion of basically the 500 largest U.S. companies and certainly are diversified, at least within large-cap stocks in the United States. The problem, as Buffett might see it, is that in selecting the index route you are buying portions of companies that you likely either do not understand, or worse, have never heard of. The problem becomes much more apparent when you get into the realm of smaller-cap funds or international equities. To be sure, these types of diversification can add benefit. However, much in the same way that you wouldn't buy something and then ask what it is later on, it isn't necessarily rational to own something you know nothing about. You cannot have expectations for such a thing.

"If a business does well, the stock eventually follows".

This can be difficult to keep in mind during a downturn in the market. For example, Coca-Cola went from a high of around $64 a share in early 2008 to a low around $39 in 2009. If you bought and held KO throughout this time, you might have thought that the sky was falling. But in this time frame KO was able to raise its earnings per share from $2.49 in 2008 to $2.93 in 2009. Furthermore, Coke increased its dividend for the 47th straight year from $0.38 a quarter to $0.41. The business was doing fine; it was people's expectations that were the problem. In 2011 KO made $3.69 a share in earnings, recently increased its dividend for the 50th straight year to $0.51 a quarter, and is now trading around $75 a share.

"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price".

It seems that too much of people's buying action is driven by the relative price of a security. People have a tendency to go to the "Oh Bank of America (BAC) is cheaper than a Happy meal, I have to buy" sentiment. But consider this context within your everyday life. If you go to the grocery store you will surely be met with a variety of things that will be on sale. But the fact remains that you don't have to, nor will you, buy something just because it goes on sale. If you never liked lima beans and they happen to go on sale, you're not going to buy lima beans anyway; likewise just because a security is cheap doesn't mean that you should buy it. Now if you happen to think that the security represents a worthwhile expenditure such that it fits your investing criteria and also happens to be cheap, then by all means-- buy away. But it's more likely, much like in the grocery store that you're going to have to pay a premium for quality. This is okay-- if you sit around waiting to buy Procter & Gamble with a Price to earnings ratio under 10, then you might never buy a share.

"Time is the friend of the wonderful company, the enemy of the mediocre".

A good indicator of whether or not you have a solid business on your hands is how long the company has been in business. After-all, businesses that lose money don't get to call themselves businesses after a while. When I look at the fact that Johnson & Johnson and Coca-Cola were founded in 1886, and Procter & Gamble in 1837, I don't exactly have alarms going off in my head that suggest these businesses will fall apart in the next couple of decades. More than that, their solid string of not only paying a dividend-- but also increasing them-- indicates that the longer I am a shareholder, the more reward I stand to gain. PG has increased its dividend for 56 years in a row, Johnson & Johnson and Coca-Cola for 50 straight years, PepsiCo for 40 years and McDonald's for just 35 years. I can't assure you that this will continue into the future, but I can say that I feel pretty good about the prospects.

"Wide diversification is only required when investors do not understand what they are doing"

Let's go back to the SPY example of essentially owning portions of the 500 largest U.S. companies. To be fair, there isn't anything inherently wrong with this strategy. After-all, the market has proven time and again that it is a worthy investment to almost any alternative. More than that, you have teams of very smart people that are not able to consistently beat the market. But there are some basic issues aside from the fact that you likely do not know how every single company in the index makes money. For one, you are buying all 500 companies simultaneously. That is, while some companies might be in a price range that you are comfortable with, it is probable that others will be trading at a price that is higher than you would reasonably like to pay. But in buying an index you have no say as to the specific prices you are paying. Moreover, you might not want to buy some of the companies at any price. For example, you could have a moral objection to cigarettes and thus not want to buy companies like Altria (MO). In purchasing an index that includes such companies, you have no say in this distinction.

"The best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago."

Last decade McDonald's was still selling burgers. Procter & Gamble still had brands like Tide and Bounty. Johnson & Johnson was still selling Band-Aids and Listerine. Coca-Cola was going strong and PepsiCo was right there with them. I think it would be a pretty sensible bet to assume that in the next five or ten years, these companies won't be doing anything inherently different from what they excel at today.

In finding your own core holdings I am not suggesting that you have to embrace my rationale or agree with the corresponding terms. I am simply suggesting that the likelihood of investing success diminishes substantially if one chooses not to adhere to a prudent strategy. There are many ways to get there. By no means should anyone have all of their eggs in one basket; but the very nature of the system requires that you must have some eggs and eventually a limited way of transporting them. I would strongly advocate that your greatest exposure be of the utmost quality.

I will leave you with this final Buffett-ism:

"All there is to investing is picking good stocks at good times and staying with them as long as they remain good companies"

Disclosure: I am long KO, PG, JNJ, PEP, MCD.