If you have ever gone through the process of purchasing a house then you already understand the basic concepts of analyzing a stock; they’re not much different. I was reminded of this recently as my wife and I began agonizing over the possibility of moving again to support our growing family. Since we have four girls and one boy, I recommended to my son, Gavin, that he and I start bunking in the basement once the teenage years hit as an easy solution to an otherwise complex challenge. Naturally, my suggestion was met with an eye roll from my wife, which I think means no. Given this resistance to my idea, we’ve engaged in the house-buying process, which I’ll illustrate is not unlike buying a stock.
1. Location, location, location
Buying a great house in a terrible neighborhood is not going to help your home value. Similarly, when it comes to owning stock in a company, the same approach holds true. For example, no matter how great a horse and buggy company was in the 1920s and 1930s, the rapidly changing industry completely eliminated all of these companies by 1939. It is often best to try to avoid companies being completely disrupted by new competition. Like a great house in the wrong neighborhood, you simply can’t do enough to ‘fix’ that house to make it a solid investment. When buying stocks as long-term investments, it’s better to own companies with wide moats around them or economic barriers to outside competition whom can easily adapt to the changes of the landscape around them, thus keeping them ‘in the right neighborhood’.
2. Make your money on the buy—do not overpay
Before you make an offer on a house, you naturally check the neighborhood for comparable house sales to get an idea of what people are willing to pay. Seeing house prices in the context of specifics like square footage, material quality, added amenities, yard size, and other factors allow a fair price to emerge. If comparable homes aren’t selling for comparable prices, it begs the question, “Why?”.
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 a revenue stream is higher for Microsoft and therefore generates a higher acceptable value per dollar of earnings. It’s like comparing a home with granite counters to one with laminate. Of course, both are within the “normal” price range for the neighborhood and worth a good look. By contrast, Netflix’s stock asks that a buyer pay $105 per $1 of earnings! Since we make our money on the buy and not the sell, it’s best to avoid those companies that have excessively high prices compared to the neighborhood in which they exist. 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. 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, given enough time. For example, materials to build a home will likely cost more 10 years from now, therefore your home is likely to be valued higher as well.
Inflation, the rise in prices, is also the reason we’re forced to invest in the first place. If we were to simply hold each dollar in our hand, it would lose value as its purchasing power declines relative to rising prices. To combat this loss of money value, we own stock in companies that are able to leverage the dollar to create a profit or interest for us that outpaces inflation. Therefore, the magic of investment returns versus inflation is time. If you make a smart purchase, waiting a long period of time allows a certainty to get all of your money back, and very likely much more.
4. Focus on the foundation, not the glamour
It’s easy to get caught up in the glitz and glamour of a hot stock. Oftentimes 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 quality. Given enough time, we can fix the minor stuff by refreshing the paint, bringing 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 its 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, but we must ensure the foundation is strong. We want to validate that 10 years from now, the company will still be 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’ll look elsewhere.
5. Make sure it fits your needs
Buying a home that doesn’t match your needs will eventually make you very restless. As our family has grown, we’ve 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’s vital to be comfortable in your house or it becomes very difficult to allow time to work its magic.
We find this same principle vital to long-term investment success. Getting restless at the wrong time will permanently impair results. Matching a portfolio of investments to your needs so that you can feel comfortable owning it for 5-10 years is imperative. For example, if you’re in a phase of life when you want or need solid income from your investments to meet your needs, then you should feel comfortable in an income-focused portfolio that’d designed to do just that. Perhaps you prefer higher growth investments that can match or beat the major indexes instead, in which case an income portfolio design would make you feel very restless as you watch growth markets potentially outpace your income portfolio.
Risk, return, income, tax, and investment style are like finding the right amount of bedrooms, ideal countertops, and most favorable layout in a home. We offer investment 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’s going to be where you call home for a long time.
