In a couple of recent posts, I’ve covered the importance of a sound investment process, preferably something that’s written down; I looked at how market returns are typically better as we come out of bear markets, and I also wrote about how we can try to profit from bear markets by building a portfolio that looks like an index, but one that’s permanently at bear market valuations.
So how would that work? How do you actually build a market-beating portfolio that always behaves like the FTSE 100 when it was recovering from the 2003 or 2009 market lows?
I guess the first thing to do is look again at the FTSE 100 and really drill into our heads what it is that makes these indices so hard to beat for professional and private investors alike.
Indices almost never go bust
I’m sure market historians could correct me on this one, but the general assumption is that the FTSE 100 is never going to go to zero, and if it ever did, we’d have better things to worry about anyway, like food and shelter.
What’s so great about this is that it means you can get into the market at crazy low valuations and not have to fear a permanent loss of money. Okay, so there may be some fear about getting in when everybody else is buying gold and baseball bats, but if history is any guide, that’s usually the best time.
Compare that with investing in individual companies. If you buy in at low valuations, there is often a significant risk that it will be money down the drain. Unlike the FTSE 100, individual companies do go bust, and most of the time, shareholders get nothing back whatsoever (other than an education on what to avoid).
Indices grow their earnings power and dividends faster than inflation most of the time
If you look back to my post on market timing, you’ll see that most of the time, the earnings power (which I measure as the rolling ten-year average earnings) goes up. It’s also true that most of the time the dividend goes up, and that both these measures go up in real terms faster than inflation can eat away at them.
Compare that to fixed-interest investments, and it’s one of the major reasons that equities outperform other assets in the long run.
This ability to grow earnings above inflation, in the long run, is another advantage that indices have over individual companies. Most individual companies don’t grow as fast or as consistently as the index. Sometimes they’ll make a loss, which an index will almost never do. Quite often, they’ll cut dividends, or not pay them at all, while the steady dividends from the index are an always positive addition to total returns.
Another reason that steady, long-term growth is a good thing is the reduction of risk, in this case, the risk of a permanent loss. If your time horizon is long enough, there is virtually zero chance that you will make a permanent loss, even if you bought at the worst possible time, like 1999. Eventually, the economy will grow and the market’s dividend yield will increase to the point where previously astronomical valuations become bargain valuations. I’ll say that again –
If your time horizon is long enough it’s almost impossible to lose money with a good quality index
That just simply isn’t true with individual companies. There are many examples of companies that had insanely high valuations, but then something bad happened and the shares fell off a cliff. After that, the company never grew enough to force the share price back up to its previous lofty heights. The result? An investment which never breaks even.
Beating the market year after year is hard, but not impossible
These two factors, which combine to create an asset which is almost certain to grow in value given enough time, are the key reasons why the professionals find the FTSE 100 so hard to beat.
They have many very clever strategies, but I think that, for the most part, they focus on the wrong things. They tend to have short time horizons of a year or so, in which time returns are largely random, and they focus on news and forecasts, one of which is random while the other is of questionable value.
I think the best route to having a good chance of beating the market is to build something which looks like the market but on steroids.
The goal would be to build a portfolio that:
- grew earnings and dividends consistently, and consistently faster than the market
- had a higher dividend yield than the market at all times
- had a very reliable dividend
- was no more volatile than the market
- was virtually certain to grow in value in the longer-term
- had virtually no chance of generating a permanent loss of money
- had smaller peak to trough falls in bear markets
A defensive value investing strategy for achieving this would look something like this:
- Invest in companies that are likely to grow earnings and dividends faster than average in the future (i.e. faster than the market)
- Invest in companies that are able to grow earnings and dividends consistently, year after year (consistency is good because it helps to show that growth wasn’t a one-off fluke)
- Invest in companies where debt levels are easily manageable
- Invest in these companies when their dividend yields are high
- Invest in these companies when their valuations (using PE10 or similar) are low
- Invest in a diverse group of these companies so that some zig while others zag, hopefully reducing volatility, as well as the fear and irrationality that comes with it
- ‘Trade up’ your holdings on a regular but relatively infrequent basis to realise profits when a stock goes up, and use that profit to buy something else which is depressed and therefore offers better value (i.e. more growth, dividends and earnings for your money).
I had a look over a few companies recently, and looked at the annualised growth in dividend rates. Some of it has been mindblowing. Did you know, for example, that BATS (Brit Amer Tobacco) has increased its dividends by 15.3% pa (smoothed out, of course) over the last decade? Difficult to believe from a boring fag company, isn’t it? RWD (Robert Wiseman Dairies) managed a slightly higher 15.7% pa increase. But get this: dull-as-dishwater VOD (Vodafone) increased at an annual rate of 21.1%, and I’m not even including recent special dividends. Then there’s SGE (Sage), the accounting software company, that has shown a rate of increase of 23.1%. Pretty spectacular, no?
Hi Mark, yes it can be pretty surprising how much dividends grow over time and how often these things go ‘under the radar’. I haven’t looked, but something like VOD probably also increased the payout ratio (or reduced the cover, same thing), so earnings and the intrinsic value probably haven’t gone up at 20% pa.
And also, and more importantly, it depends on what the yield was at the time! VOD is a great example of this. The financial results have been great, but the shareholder returns have been terrible because of the ridiculous starting valuations from the dot-com era.
But yes, boring may be boring, but it sure can bring home the bacon. If you want excitement, go bungee jumping!
It seems to me that there are two ways to consistently beat the FTSE via an index-like approach to equity investing:
1. an equal-weighted basket of the 100 stocks instead of a market-weighted basket, as presently’
2. a value-weighted basket of the 100 stocks, as here http://valueweightedindex.com/
The difficulty with your 7-point list is that each point requires discretion and some level of expertise.
As an aside, I believe it is well known that the S&P 500 ex the airlines handily beats the S&P 500 over the medium- and long-term.
Hi Red, I totally agree. An equal weighted index should be better than a cap weighted one. You can download (PDF) a factsheet for the FTSE 100 equally weighted index here:
http://www.ftse.com/Indices/FTSE_100_Equally_Weighted_Index/Downloads/FTSE_100_Equally_Weighted_Index_Factsheet.pdf
As at the end of 2011 the equally weighted index had 78.1% over 10 years compared with 52.3% for the cap weighted index. I would expect yield to be slightly better too.
As for your second point, I have ‘the big secret for the small investor’ in my book in-tray, although I pretty much know what Greenblatt is going to say as I’ve read and watched various interviews and articles. The process that I’ve outlined above is an alternative way to do the same thing as Greenblatt has done with his ‘value weighted’ index. Of course, it’s a bit different because Greenblatt holds hundreds of stocks and rebalances daily, using sophisticated software, whereas my approach is geared towards a manually managed portfolio, but the underlying goals and philosophy is the same.
I don’t think my system HAS TO require discretion or expertise. As I’ll show in an upcoming post, you can do this sort of thing entirely mechanically. But mechanical systems tend to work best when the investor is not involved AT ALL. That’s why the FTSE 100 works – because it’s mechanical and the investor does literally nothing to manage the holdings. What Greenblatt found with the original magic formula investing system was that people either didn’t want to do the work of picking the stocks from a mechanical screen because they weren’t interested (they just wanted the results), or they were interested and couldn’t stop themselves from fiddling with the system and, on average, producing worse results than the purely mechanical system!
So I would say that while defensive value investing can be done mechanically, it is more likely to be applied with some level of discretion, which then involves expertise (or at least it should), because active stock pickers like to dig in and at least know a little about the stocks they hold, rather than just holding a list of names spat out by a computer.
Anyway, thanks for the comment and apologies for the lengthy reply!
Ah, alright — you meant it to be applied mechanically and I agree that that’s the way to do it. Thanks for both the post and the thoughtful reply.
I’m not sure I’d say that I meant it to be applied mechanically, it’s just that I think it could be applied mechanically. The way I use this system it’s probably 80% mechanical with 20% discretion/common sense/qualitative analysis to help me fell comfortable with each investment. I basically want to know that it’s the sort of thing I want to invest in and isn’t something ‘whacky’ which has somehow crept in through the mechanical screen.
However, I very much understand your preference for the mechanical approach as that’s my theoretical preference too, but my real-world preference is to include some qualitative analysis for the reasons I mentioned above.