March 23, 2018
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Yes! If you have ever gone through the process of purchasing a house then you already understand the basic concepts of analyzing a stock.
My wife and I are currently agonizing over the possibility of needing to move again to support our growing family and possible bedroom needs of having 4 girls and 1 boy. I recommended Gavin and I start bunking in the basement once the teenage years hit as an easy solution. My suggestion was met with an eye roll, which I think means no. We have generally found the following are the key steps in buying a house…. and a stock:
1. Location, Location, Location
Buying a great house in a terrible neighborhood is not going to help your home value. When it comes to owning stock in a company, the advice is the same. No matter how great a horse and buggy company, the changing industry from 1920 to 1939 completely eliminated all companies. It is often best to try and avoid companies being completely disrupted by new competition. It is better to own companies with wide moats or economic barriers to outside competition whom can easily adapt to the changes. When new drinks become the fad, Coca-Cola can eventually produce them and keep up. However, the ability of a singular energy drink company to compete when organic drinks become the “in” is near impossible. Unless you have the supply chain and logistics of Coca-Cola, you may find yourself in the wrong location while the neighborhood around you declines.
2. Make your money on the buy – do not overpay
Before you make an offer on a house, you naturally check the neighborhood for house sales to get an idea of what people are willing to pay. Often times you would find similar homes and calculate a price sold to the number of square feet. You compare the pros and cons of each home such as material quality, added amenities, yard size, among others. If a difference between the price per square foot exist then it becomes wise to ask why? Perhaps it is the neighborhood, layout or the materials; but usually, a reason exists.
Stock analysis is done in the exact same manner. Why would I be willing to pay $25 for every $1 of earnings to own Microsoft but only $15 for Apple? In short, they operate in completely different neighborhoods. Microsoft derives a large number of sales from consistent subscription-based software and cloud services. However, Apple relies heavily on product sales. Product sales ebb and flow more on style, competition, and economic activity when compared to a monthly subscription payment. The certainty of payments and revenue stream is higher for Microsoft and therefore generates a higher acceptable value per dollar of earnings. It is like comparing a home with granite counters vs. laminate. Of course, both are within the “normal” price range for the neighborhood and worth a good look. Contrast with Netflix that cost $105 per $1 of earnings. By comparing the neighborhood we can see that Netflix looks like an owner asking a ridiculous price. Or perhaps, they are the first house in a new neighborhood. With no neighbors to compare and a price well above surrounding homes, they appear like a higher risk. Since we make our money on the buy, it is best to avoid those companies that are excessively high compared to the neighborhood. Sometimes they work out, but more often than not it becomes hard to find a buyer down the road at the price we paid. Do not overpay!
3. Plan on staying 5 years to make money
Compound interest. Compound interest is the eighth wonder of the world. He who understands it earns it … he who doesn’t … pays it. Compound interest is the most powerful force in the universe. – Albert Einstein
Time is the magic behind any investment. It is the fourth dimension that both allows and forces us to invest. Given enough time we know consumption in a free market will grow. As consumption grows, the price of goods grows, which fuels more revenue and a higher dollar amount of consumption. This cycle is the foundation of inflation. Because inflation will happen, most home prices will increase. Materials to build a home will likely cost more 10 years from now, therefore your home is likely to be valued higher.
It is inflation that also forces us to invest. Rather than allow each dollar we hold to lose value, we desire to own a company who will be able to leverage this dollar to create a profit or interest for us that outpaces inflation. Since inflation happens due to higher dollars of consumption, stocks tend to outpace inflation the most. They sit on top of the investible food chain. The magic for inflation and investment returns is time. If you make a smart purchase, waiting a long period of time allows a certainty to get all your money back, and very likely much more.
4. Focus on the foundation, not the glamour
It is easy to get caught up in the glitz and glamour of a hot stock. Often times a company story can blind investors to what is really going on underneath the surface. When I look at a house, the first place I head is into the basement to check out the foundation and construction. Given enough time we can fix the minor stuff, refresh the paint, and bring any home back to style. However, if the foundation has issues, it becomes a large uphill battle with many unplanned expenses. Similar to the basement, our first look for any company is the balance sheet. We want to know what type of cash, assets, and debt the company holds. Sales will ebb and flow over long time periods. Some quarters will be better than others, but we must make sure the foundation is strong. We want to validate that 10 years from now the company is still standing which will allow time, inflation and interest to accrue in our favor. You can have all the bells and whistles, but if the foundation looks questionable then we will look elsewhere.
5. Make sure it fits your needs
Buying a home that does not match your needs will make you very restless. As our family has grown, we have encountered this feeling a number of times. Sometimes we can modify the home to fit our needs and other times we have to simply sell and move on. It is vital to be comfortable in your house or it becomes very difficult to allow time to work its magic.
We find this principle is vital to long-term investment success. Getting restless at the wrong time will permanently impair results. You need a portfolio that matches your needs so you can feel comfortable owning for the long run of 5-10 years. If you are an income client and want solid income to meet needs then you should feel comfortable as long as income is being generated regardless of short-term ups and downs. Perhaps you prefer higher growth that can match or beat the major indexes, in which case an income design would make you feel very restless as you watch growth markets outpace.
Risk, return, income, tax, style are like finding the right amount of bedrooms, countertops, layout in a home. We offer strategies that range from low risk to market beaters; all with differing styles, pros, and cons. Finding the right match for your needs is the most critical component. After all, it is going to be your home for a long time.
Evergreen Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.