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Q&A: A Lazy Man’s Guide to Portfolio Construction and Stock Selection

Question: What is your approach to portfolio management and evaluating particular companies?

DumbWealth Reader Question:

What is your approach to portfolio management, adding or closing particular investments, and evaluating particular companies when you are looking to add one?

Answer:

There is quite a wide range of things I consider when constructing my portfolio and adding or removing particular holdings. My aim is to build a portfolio that doesn’t require a lot of tending to over time.

My first overall consideration is the overall allocation to various asset classes and sectors within those asset classes. As my time horizon is fairly long, my portfolio is more heavily weighted to risk assets, like stocks and high yield bonds. I do own some investment grade bonds too. And from time to time I will have an allocation to gold. Since I have a long time horizon, it makes sense to hold assets that will grow over long periods of time. Stocks tend to fit that description.

I consider my job and sources of retirement income when choosing how much risk I can take. I currently work in a cyclical industry that is directly impacted by the markets. This reduces my risk tolerance because my income would be at risk at the same time as my portfolio. In contrast, I have a small defined benefit pension plus standard government retirement benefits (i.e. a guaranteed source of income at retirement), allowing me to take on more portfolio risk. On balance, I think these variables offset each other.

When selecting stocks to hold, I take the lazy route. I don’t want to trade in and out of holdings. Instead, I prefer to buy companies that I hope to own forever. I want to own well-run survivors. Good companies with sustainable, inimitable competitive advantages in industries that can’t easily be displaced by new competitors.

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.

Warren Buffett

Many investors refer to these sustainable, inimitable competitive advantages as ‘wide moats’. Essentially, these advantages protect companies from the advancing army of competition. Wide moats can take several forms. The following examples are provided by Morningstar:

Network Effect. The network effect occurs when the value of a company’s service increases for both new and existing users as more people use the service. For example, millions of buyers and sellers on eBay EBAY give the company an advantage over other online marketplaces. The more sellers there are on eBay, the more likely buyers are to find what they’re looking for at a decent price. The more buyers there are, the easier it is to sell things.

Intangible Assets. Patents, brands, regulatory licenses, and other intangible assets can prevent competitors from duplicating a company’s products, or allow the company to charge a significant price premium. For example, patents protect the excess returns of pharmaceutical manufacturers such as Novartis NVS. When patents expire, generic competition can quickly push the prices of drugs down 80% or more.

Cost Advantage. Firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or they can charge market-level prices while earning relatively high margins. For example, Express Scripts ESRX controls such a large percentage of U.S. pharmaceutical spending that it can negotiate favorable terms with suppliers like drug manufacturers and retail pharmacies.

Switching Costs. When it would be too expensive or troublesome to stop using a company’s products, the company often has pricing power. Architects, engineers, and designers spend entire careers mastering Autodesk’s ADSK software packages, creating very high switching costs.

Efficient Scale. When a niche market is effectively served by one or a small handful of companies, efficient scale may be present. For example, midstream energy companies such as Enterprise Products Partners EPD enjoy a natural geographic monopoly. It would be too expensive to build a second set of pipes to serve the same routes; if a competitor tried this, it would cause returns for all participants to fall well below the cost of capital.

What you’ll notice about these characteristics is that they can’t easily be summed up by a single number. Data points like standard deviation, Beta, p/e ratios serve their purpose but they don’t tell you about the long term prospects for a business. Before diving into the plethora of data points, it is critical to first have a qualitative understanding of what the business does, what sets it apart and how it is insulated from competitive forces.

Once I’ve done this there are some data points I pay attention to:

Revenue: If a company isn’t growing revenues over time then something is fundamentally wrong with the business or industry. Revenue flows through to earnings and cash flows, so a company with declining revenues can only engineer good shareholder returns for so long. If a company can’t grow its customer base and earn more from each customer over time, I don’t really want to own the stock.

Growing Dividends: I don’t chase yield. Instead, I prefer to invest in companies that pay consistently growing dividends. I like companies that can grow dividends above the rate of long-run average nominal GDP so that my income stream grows faster than inflation. (This, of course, requires growing revenues.) Many of my holdings have dividend growth rates closer to 7%+, doubling my dividend income every ten years. While I agree that technically it’s total returns that matter, a consistent and growing dividend payout overlays a level of discipline on management. It also implies that company executives – i.e. those who know the most about their business – are confident in the company’s ability to generate cash. Some research has shown that companies that pay growing dividends outperform companies that don’t pay dividends over the long run. Of course, there are great examples of the opposite. But as a lazy investor, I want to buy good companies at fair prices and that often means investing in proven businesses that are able to pay dividends. Moreover, the psychological benefit of seeing dividends paid into my account regardless of the daily, weekly, monthly stock price fluctuations keeps me from making irrational sell decisions.

Sustainable dividends: Not all dividends are equal. This is important if one is to avoid value traps. Sometimes a yield is high because investors expect dividends to be cut. The classic measure investors use to evaluate dividend sustainability is the payout ratio – the proportion of earnings paid as dividends. Over the long run, a company cannot pay more than it earns. Personally, I prefer to look at the dividend as a proportion of free cash flow, since earnings can often include various non-cash items. Dividends are paid with real cash, so ultimately it’s the cash flows that matters.

P/E and P/S: These valuation metrics provide a good snapshot of whether a stock is expensive or not. While P/E is often the first valuation metric people use (share price per dollar of earnings), I also look at P/S (price to sales). Again, because earnings can include non-cash items, one-time items, etc. I feel it is helpful to have a valuation metric that compares against a more stable accounting measure (revenues). When looking at valuation metrics, it’s important to recognize what you’re paying for. A fast growing company will cost more…and that’s OK. In contrast, a dying company might have a single-digit P/E ratio and 5%+ dividend yield, but over the long run it might be a losing proposition. I would rather pay a fair price to own a slice of a company I know will outrun its competitors and have a viable market (via its wide moat) for decades to come.

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