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).