Build a “margin of safety” into every investment that you make.
At the foundation of all investment decisions is a process for finding margin of safety.
Here’s a longer version of how Buffett described it.
If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.Warren Buffett again
I want to make my ground level thoughts on investing very clear. I think using these ideas and the framework I lay out will help you not only cut your risk dramatically, but beat the stock market handily. Everything I say here is rooted in historical market studies, experience and math.
Correlated Stock Market Risk
Ths stock market is extremely risky. This might seem like a self-evident cliche, but most people invest with little regard to the real risks. It is not hard to lose half of a diversified portfolio in short order.
Highly correlated stock market crashes happen one to three times per decade.
In the four decades, now including the Coronavirus Crash, there have been 9 bear markets just since 1980. And this is the era of government deficit spending and Federal Reserve monetary policy to avoid bear markets. What we should take away is that big correlated corrections are buying opportunities.
Debt Driven Company Risk
Companies fail regularly due to poor business execution and sometimes just being outcompeted. In a high debt economy, the risk of credit failures for companies without growth is every high. We are seeing debt problems in the fossil fuel industries.
When debt becomes stressed, stock prices generally get crushed. Avoid companies with high debt that need growth above recent levels to pay those debts.
As of late 2020, there are well over 100 companies in the S&P 500 with debts that they can never repay without dilution, bankruptcy or mergers that generally will not yield a premium to stock price (takeunders). Those are the “zombie” companies you will hear and read me refer to regularly. Those are the companies that make me avoid the S&P 500 (SPY) (VOO) as an index to invest in.
Most of the net cash sitting on corporate balance sheets resides within the companies in the Nasdaq 100. This is why I favor the Invesco QQQ (QQQ) as our core large cap index. These are also companies that, as a group, have sustainable growth due to durable competitive advantages.
Mild Diversification Is Best
Cutting risk does not come from broad diversification. There should be adequate though not excessive diversification.Benjamin Graham (Warren Buffett’s mentor) from his must read book: The Intelligent Investor
Graham’s quote tells us that we do need some diversification, however, it should not be excessive.
If you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk.Warren Buffett, Berkshire Hathaway: Letter to Shareholders (1993)
While we like to think of ourselves as “know-something” investors, the fact is that while we might know more than most investors, we are not perfect. Therefore, we do need some diversification to protect against what we do not know or that which changes quickly that we are not aware of.
The diversification I look for comes in two flavors:
- We will buy ETFs to give ourselves diversification across the sectors, industries and nations that we think offer the best intermediate to long-term risk adjust returns. How much you put in ETFs depends on you, but I would not have less than 25% dedicated to ETFs. It is fine to use 100% ETFs if you do not have time to research individual stocks. I split my money about 50/50 ETFs vs stocks.
- In addition, we want to own 12-20 stocks. This jives with Buffett’s 20 slot “punch card” for owning stocks with big upside and that we can keep up with the businesses.
- I think people who buy baskets of stocks to essentially build their own personalized sector ETF can own up to 30 stocks. An example of this is with REITs which do not have a good ETF. We might own 6 REITs, but because we know the sector, will not feel overburdened owning a few extra businesses.
Smart Asset Allocation
Studies have showed the asset allocation is the key driver of long-term risk, volatility and returns. Investing primarily in the best sectors, industries and nations will yield market beating results over time. Avoiding the best we can the “other” sectors, industries and nations will help us reduce risk. We do not have to be completely right, only mostly right.
Perfection is not attainable, but if we chase perfection we can catch excellence.Vince Lombardi
For our diversified asset allocation in the 2020s we want to stick with the “barbell” approach I have laid out:
Single stock risk is infinitely high. Any company can “go to zero.”
As mentioned above, high debt, no growth companies are at the greatest risk of massive stock price declines. In general, we want to avoid those traps.
The only way to make single stock risk acceptable is if you are investing in companies that can significantly beat the stock market averages and be leaders in their sectors, industries or countries. Simply put, only try to invest in great stocks, you’ll get good stocks in your ETFs and on accident.
Always remember this…
All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don’t work out.Pete Lynch Fidelity Magellan Manager
Thus, we only want stocks that can handily beat the stock market. If we carefully pick our stocks, a few will take off and the rest will generally not hurt us much or be decent, but not huge, winners.
The common traits for finding potentially big winning stocks are:
- companies with relatively low debt.
- companies with high growth rates.
- companies that own assets the stock market does not assign proper value to.
Usually, we will want to buy great companies during some sort of correlated correction. These corrections can happen at the broad market level, i.e. S&P 500, or within a the sector, industry or nation. Cyclical corrections within industries offer buying opportunities a few times per decade, i.e. semiconductors.
Sometimes, an entire industry is underappreciated. We have seen that for years with alternative energy as there is a cohort of investors stubbornly and ideologically tied to fossil fuels, who doubt that clean energy will take off. I believe a massive bull market in clean energy is just beginning and we need to use corrections to buy the dips until all are believers and they overbuy what we already own.
There is also opportunity on an ongoing basis to find companies that simply have assets that are more valuable than the market is pricing in. Usually those assets things that are hard to replace or compete with, i.e. media libraries, or gas pipelines, or resources…
The Investing Quick Take
We want a portfolio that holds some assets in ETFs and some in high potential stocks. You decide your mix based on your goals and risk tolerance.
Ultimately, having a great asset allocation gives your portfolio direction, diversification and a likelihood of beating the broad market. Exchange Traded Funds, or ETFs, drive your asset allocation.
Owning as few as 12 stocks, or up to 30 if you have the time to keep track, can add the component of “alpha” or big risk adjusted returns. Kirk has picked over 20 ten baggers since 1996 and thinks in this age of change, there is a chance for 20 more in the next 5-10 years.