Basic Guide To Successful Investing - Part I

Mar. 18, 2018 8:34 AM ETJNJ73 Comments

Summary

  • My approach to investing.
  • Understanding Free Cash Flow and its importance.
  • Letting compound interest do much of the work for you.

Introduction

A few years ago I wrote a very popular series of articles about how I created my own portfolio over a lifetime. As time passes I continually refine my approach and since about three million new potential readers have been added to the Seeking Alpha platform I thought a refresh was in order.

This series of articles is meant to provide a guide for investors of all ages, to help each one determine reasonable goals and develop a plan to attain those goals over their respective remaining investing lifetimes. I spend much of my time during retirement now writing articles to explain complex concepts in simple, easy to understand language that almost anyone can understand. That is my primary goal: taking the fear out of investing by explaining a step-by-step approach that anyone can follow and use to achieve success.

Obviously, there are many ways to build an investment portfolio and allocate funds across different classes of assets. The method described in this series is how I have learned over a lifetime that works best for me and I believe it can work for anyone. Having a set of simple, straightforward principles and specific goals can help one stay on the right path and my hope is that my explanations will help readers to formulate a system of investing that works for them.

The approach I explain in this series is intended to provide a flexible set of guidelines that can be modified to fit any investor’s needs. Included will be three systematic methods of adding investments that are proven to work over the long term. Most folks think that these strategies only apply to stocks but, as you will see, they are useful tools for investing in almost any type of asset.

What are the different types of assets used for investment? The list can get long if we break down each class of asset into its subgroups like stocks into mutual funds, ETFs (exchange traded funds), MLPs (master limited partnerships), closed-end funds, etc. I will describe my preferred subgroup that I prefer in each asset class and explain why I like it. But for now, I will list only the major asset classes that I consider to be easily investable for the average person: stocks, bonds, real estate, and commodities (including metals). I do not cover things like collectibles, art or digital coins (like Bitcoin or ethereum) because I have found that those items tend to be too speculative for the average investor. Mine is a very conservative approach to building a retirement nest egg.

I will go into detail about how to understand your investment horizon(s) and why it is important, how to value assets of different classes in order to find bargains, using the concept of compound interest to make your money work for you, how I allocate funds between asset classes, why I find it important to invest for a rising income and total return rather than just appreciation, why it is imperative to always have some cash available for emergencies, where I invest my “cash” while I wait for bargains and much more to help develop a lifelong plan to meet your financial needs.

If you are just starting out on your investment adventures, it is important to establish a plan with reasonable, achievable goals and intermediate milestones. Even if you are well into the adventure it is never too late to start using milestones and setting a long-term goal. I suggest only focusing on the next milestone to alleviate the inevitable frustration that creeps in upon setbacks (which are a natural part of investing). Each milestone is within reach in just a few years, so it is always achievable as long as you stick to the plan. Once one milestone is achieved, just plod on toward the next one. Success breeds more success. Never get too aggressive with your goals or milestones. Keeping milestones achievable within a reasonable time period is important. It allows one to enjoy the sweet taste of success over and over again at regular intervals. That, in turn, helps you to stay the course knowing that the next milestone (and time for celebration) is coming and that you CAN make it happen just like the last time. The more success you enjoy the more motivated you will be to keep doing what works without deviating from the plan. The most important milestone is always the next one. It is very similar to team sports. Concentrate on the present and proceed toward the future one step at a time. You cannot win the championship unless you win the game you are in right now.

One of my guiding principles for investing is to invest like a millionaire (maybe I should have used billionaire since a million dollars does not buy as much today as it did in the past). I will devote a full article to this concept because it really is that important and because this approach is rarely understood by most investors. It generally leads to lower risk and overall higher returns. Of course, there are specific investing vehicles available to the extremely wealthy of which we mortals cannot take advantage. But, just the same, the underlying concept still applies and I believe you will find it useful.

What is your time horizon? That is something most people do not give enough thought to when planning for retirement. You will need your nest egg to last another 20-30 years (and perhaps even longer) after you retire. You need to consider what inflation could do to the purchasing power of your retirement income and how to stay ahead of it. Make sure your goals align with your needs. This series will address these issues and many others.

In the following installments I will lay out my strategy for investing, primarily in equities but including real estate, fixed income (bonds, CDs, etc.) and commodities (including precious metals) that I have developed over a lifetime. For me, investing is more of a process of elimination using a rules based selection process that guides me to the best investment for long-term appreciation and income. There will also beshort interludes throughout the series referring to real life examples of average people who amassed millions of dollars without anyone noticing. When they died each one left behind a fortune to the benefit of heirs and/or favorite charities. These were people with a plan who stuck to it year after year. They were also people in average jobs and no special advantages; the sort of people to which I can relate and you should too. My investment philosophy has been inspired over the years by similar stories. I trust that my words may become your inspiration.

A Unique Approach to Investing in a Complicated World

When I was in my 20s and just out of college I set a goal to save $25,000. Back then (in the 1970s), that was a lot of money. I attained that goal within four years. My next goal was to double it $50,000; then $100,000; and each milestone thereafter was to add another $100,000. In looking back, those goals were really just milestones leading to the ultimate goal of financial security and independence. I did not know how much I would need for retirement at the time so I simply set a new milestone each time one was achieved. One of the best things about having a plan and sticking to it is that it gets easier to achieve with each new milestone, especially after hitting $300,000, because from that point forward you are not alone in your quest. Your money is working with you and for you to achieve each new milestone thereafter. Or, at least, it should be if you are investing correctly. I must admit here that I strayed from the path a few times and got behind as I still had a lot to learn. My sincere aim in writing this series is to help others to avoid many of the pitfalls that I encountered along the way.

My biggest hindrances were my lack of knowledge and the naïve expectation that I could beat the average investor while accepting too much risk. Believe me, experience and knowledge have helped me to reduce my short-term goals and remain more focused on the path toward the longer term goals. Stated in another way: successful investing is not winning the lottery, it is finding a proven strategy that has worked for millions of other individuals throughout history and sticking with it. The good news is that there is more than one strategy that will work; you just need to find the one that you can stick with over a lifetime and make it work for you.

I was good at saving, but the investing part was not my forte early on in life. That came with experience and a lot of study and training, not necessarily in that order. Initially I was accepting more risk than I needed to in the hope that I could achieve those milestones faster. In contrast to the now-famous quote of Mr. Gecko from the movie, “Wall Street,” greed is not good for most investors. It generally leads to greater inconsistency and too many unnecessary setbacks. If you win, you win big; but when you lose, you lose big! When an investor loses 50 percent of his or her portfolio s/he will need a gain of 100 percent just to get back to even. Never forget that! My number one rule is to limit losses. I believe someone else of greater fame with the initials of W.B. has been quoted in a similar fashion. Learning how to limit or avoid major setbacks is one of the most important keys to successful investing. I will explain how to implement rule number one later in the series.

The point I want to stress here is that it took me more than a decade to realize what I was doing wrong. Then I read an excerpt from a study that illustrated how more than 40 percent of the total return of the S&P 500 had come from dividends when measured over the very long term (such as in a typical lifetime of 30 to 50 years of saving and investing). Suddenly it dawned on me that by looking solely for appreciation (rather than total return) I could be missing out on as much as 40 percent of the potential return that a stock portfolio could offer. That was revolutionary and so began my investment approach evolution.

Another Radical Improvement

One other event happened more recently that helped to shape my investing philosophy. Before I discovered the Friedrich algorithm I was almost exclusively focused on creating new streams of future income and, to a certain degree, I still do. Our current income is adequate to maintain our lifestyle, but it never hurts to have a little more.

The change has not been radical but it is still significant. I still look for total return, but now I rarely dismiss a stock just because it does not pay a dividend. I have been a rules-based investor and continue on that track. The difference is that I now add more potential growth to my portfolio that I can turn into an income stream at some time in the future when I need or want to do so. This has become ever more difficult to accomplish as the markets continue further into what I would term overbought territory. So, selectivity has become imperative.

I want to introduce one ratio that makes finding future growth potential a much simpler task for me than anything I have used in the past. We call it the Price to Bernhard FCF (free cash flow) ratio. Mycroft Research conducted a back test on the components of the Dow Jones Industrial Average Index (DJI) to determine just how powerful this ratio could be over time. The results were astounding! A compound annualy rate of return of just over 21% over a 60-year period. The DJI compounded at 6.77% over the same period. The difference between what one would have turned $10,000 into by using this one ratio consistently over time to select stocks compared to just investing in DJI and letting it ride was absolutely staggering. You can check the results and details of the study at this link. You will be glad you did.

The Importance of Free Cash Flow

I should explain that Bernhard FCF is calculated differently than the traditional definition of FCF. It was originated by Arnold Bernhard, founder of the Value Line Investment Survey. He apparently determined that changes to working capital and most one-time non-cash expenses are temporary and fleeting in nature so that neither should be considered when assessing the long-term potential growth prospects of a company. Most one-time non-cash expenses are related to asset write downs in value or restructuring charges. Both categories are the result, in my opinion, of mistakes made by management in the past that need to be corrected to properly reflect reality in the present.

Many companies categorize as much as possible these days, and for years now, as one-time events even though such events keep occuring almost every year. Such expenses really are not one-time in nature and eliminating such expenses from operating results is the equivalent of giving management a continuous string of passing grades on an incessant flow of poor decisions. All those mistakes cost the company, and its shareholders, real money in the past. Continuing to reward management for making mistakes by disregarding them simply ignores any semblance of accountability.

So, by not adding back these expenses I feel (and I believe Mr. Bernhard would, as well) that we get a better picture of the true ability of a company to generate FCF on a sustainable basis. Management will make those mistakes again and again in the future so eliminating them as though nothing really happened does not make sense. The formula Bernhard created for FCF was simple:

Net Income + Depreciation + Amortization – Capital Expenditures

Changes in working capital may free up cash temporarily but more often than not such changes are transitory as such items as inventories, accounts receiveable and payable may ebb and flow with changes in the economic, business or industry environment. Many times these annual changes are not within the power of management to predict nor manage in the short term and tend to end up back within a range relative to revenue levels over time. So, annual changes are really irrelevant in my opinion.

The Bernhard approach is simple, focuses on what management can control, measures consistency over time and, best of all, it works. Again, for more detail on how well it works I strongly urge you to read the back test results linked earlier in this article.

As good as his definition of FCF was, Bernhard never seemed to understand the true power of what he had discovered. He used it primarily as a tool to measure the likely range of a stock price for each company based upon the historical relationship of FCF to revenue. It was (and still is) a useful tool when used in this fashion. But there was something missing.

This missing piece, or utility, of this FCF calculation was in determining the relationship of FCF consistently generated by a company that would lead to future outperformace of the stock. While past performance of a stock cannot be considered a guide to expectations for the future, consistent management performance and financial results from the past actually do tend to be fairly predictive of what can be expected in the future to the extent that consistency provides greater predictive visibility than inconsistency.

Bernhard never determined the level of Price to FCF that would, with a relatively high probability, lead to higher future returns from a stock. That is where the back test provides some evidence that somewhere around 15 times FCF may be the right level. It is hard to argue with a 21% annual compound return. Using that ratio as the cut off for selecting which stock to buy each year the back test showed that this method beat the market average result for 55 out of 60 years measured.

There are two important things at work in that back test. First is the superior rate of return created by only owning the stocks with the greatest potential for future growth. Second is the power of compound interest; interest accruing on an investment over time plus interest on the interest. This concept will keep coming up throughout the series because it is another of the keys to successful investing.

Again, the power of compound interest is illustrated in the back test but I will include an example of how it works with a simple chart:

Chart

JNJ

data by

YCharts

If an investor had purchased 100 shares of Johnson & Johnson (JNJ) stock at the beginning of 1970 s/he would have paid about $17,700 ($177/share) back then. Assuming that the investor held onto those shares without selling any s/he would now have 14,400 shares (after 6 stock splits), now worth $1,912,320. And that does not include any of the dividends collected.

You would have received dividends totaling $1.02 per share in that first year, or a yield of ONLY .6%. But the total of dividends collected over the entire holding period is about $711,100. This gets back to including the dividends when calculating total return. Had an investor reinvested all those dividends s/he would have more than $3,000,000 from the original investment of $17,700. It took 48 years to accumulate that sum but it illustrates the power of compound interest nicely.

This is not to say that I (or anyone for the matter) can pick the next JNJ. Nor am I trying to imply that the next 48 years will provide investors with returns similar to those of the past 48. I used JNJ because it is a quality company and has generated consistently superior returns (with a few short hiccups along the way as is almost always the case with any company). I am also not trying to convince anyone to buy shares of JNJ today with the expectation that its future will mirror its past.

Most investors jump into and out of stocks after a few years, or even months, and miss the true power of long-term investing. Sure, we take a beating here and there along the way, but quality always recovers and buying a stock in a high-quality company when it is priced as a bargain generally works out better than trading in and out. Remember, you are collecting those juicy dividends along the way. The annual dividend on 14,400 share in 2017 was $63,412.

So, sticking with quality companies and investing for the long term to allow the power of compound interest work for you are the first two key elements of successful investing. I will get into more about how I identify "quality companies" in practice as we move through the series.

The purpose of all this experience chatter is to frame the answer to why I invest the way I do. I invest with a long-term investment horizon, even now at the ripe old age of 68. I need my money to last at least 20 years to provide for my wife and myself. We would also like to leave a nice inheritance nest egg for each of our two children to help them in life and to give them a good start on their respective retirement plans. Therefore, my horizon extends beyond my own lifetime and that of my spouse which is, by definition, long term. That is how I invest: for the long term and with a rising stream of income for me, my wife and for our children long after we are gone.

In the next article in the series, investing like a millionaire, we will get to the root of my investing philosophy. Once you understand this concept we can move on to developing a personal plan.

This article was written by

Mark Bern, CFA profile picture
15.16K Followers
Research on 20,000 stocks from 36 countries - made easy

Founder of Bern Factor LLC, an independent research and publishing firm located in Virginia, and CEO of Friedrich Global Research, an equities research firm covering over 20,000 companies in 36 countries worldwide . My association with the Marketplace subscription service, Friedrich Global Research, is a collaboration with Mycroft Friedrich, another contributor on Seeking Alpha. Together we have nearly 80 years of investing and analysis experience. I am a former CPA (1990 -2017) and became a CFA charter holder in 2000. I consider myself an expert in Quantitative and Qualitative analysis and have extensive experience in Technical Analysis. I also have a deep interest in stock market history and hold degrees in Economics (BS) and Management Information Systems (MBA). I have been actively involved with investment analysis since 1985 but have been a student of investing since the 1960s. I owned my first individual stock position while still in high school. I am a student of Benjamin Graham and Warren Buffett. I have achieved a uniquely diverse experience from multiple careers that has allowed me to develop a broad perspective enabling me to look at the big picture of macroeconomics all the way down to the detail of a retail unit or factory floor. In my youth I was in retail, then served in reconnaissance during my tours in Vietnam. I have been a blue collar, union worker in a factory and a manager in services, hospitality and transportation as well as a manager of professional staffs. I have more than 20 years of experience each in both the public and private sectors. I have personal points of reference that many analysts will never have. I bring more to the table than just the theories and models I have studied or built. To understand more about my investing philosophy please visit my website.

Disclosure: I am/we are long JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: DISCLAIMER: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.

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