Mail Bag: “If you are 30 years old and organizing a portfolio what would be your core investments?

“If you are 30 years old and organizing a portfolio what would be your core, what would be your aggressive picks and how would you organize that?

Ideally where should an investor be in terms of portfolio size at 30, 40. 50, 60. Etc.”

 I came across the question above so I figured the answer should be the basis of my post. 

What should my savings rate be? 

Where you should be at in terms of your age is related to the opportunity costs life allows you. If I were to say I was a lawyer who made $150,000 per year with marginal debt your goal at 40 years of age should be different from a single mother of two who makes $35,000 a year. 

What is my maximum savings rate? Knowing the answer to that question is the key to figuring out where you should be at each checkpoint in your life. I always recommend a savings rate of at least 35% of your take home income, but bills have to be paid. That said if you need a goal to shoot for, getting to $100,000 as fast as you can is your best bet. Charlie Munger, once said “The First $100,000 Is The Most Difficult” so basing your savings rate on getting to $100,000 is the ideal mindset in my opinion.

But why is $100,000 the goal? Because at $100,000 you are no longer the only source driving up your returns. At a 5% yield $100,000 is kicking off $5,000 in dividends every year that you can reinvest into your portfolio. That doesn’t seem like much, but when you factor in a dividend growth rate of 8% over the next 20 years, you will end up with $630,283, and that's without continuous contributions from yourself. At $100,000 your snowball will turn into an avalanche.

What do I invest in?

We have identified that your savings rate isn't based on your age but by what life will allow you to save. We have also established that your savings goal should be to get to $100,000 as fast you can. 

Now we can talk about what kind of businesses you should be looking at. I am a value investor which means I invest in businesses that are selling at a discount to their intrinsic values. A business is worth its free cash flows a owner can extract from the company without effecting the day to day operations. This is where I differ from many of my peers, because I believe that as minority investors we can not extract the full excess cash flows like a Warren Buffett can. The cash flows that we are subject to are what many people call dividends. So by definition to a minority investor free cash flow = dividends paid. If we can not extract the free cash flow (dividends) then by our definition we can not invest in that company because there isn't any free cash to extract. (there are exceptions)

We want dividends growing at around 5-10% every year on average. We also want dividends to be less than 60% of total earnings. The reasoning behind that is we want our cash flowing in uninterrupted. That can’t happen if the company doesn’t have a sustainable business model or if the company is losing money. All of this data means nothing on the short term, we need a history of sustained growth and stability of at least 10 years. This is the quality portion of our business appraisal  and without quality the value of a business goes down over the long term.

But even if you bought a business that grew its dividends paid by 10% for  12 straight years and its payout ratio was 40% if you pay too much for that business your returns will never be as they should. It is paramount that when you buy, you buy below the appraised value of the business.  

Figuring out the appraised value of the business isn’t exactly a science, it’s more on the lines haggling at your local pawn shop and if anyone tells you anything differently than they are making their job far more technical than it really is. 

I try to buy at a price that is cheap relative to the industry standard. The reasoning is that seldom do stable and growing businesses go on a flash sale. It does happen, but not enough to be relied upon. If I can get a good to great business that is cheaper than its peers then I know i have a decently priced business. 

There is one more component I want to address - just because a business is cheaper than its peers doesn’t mean it's cheap against the market. Remember in order for something to be cheap it has to be compared to something that is expensive. I use a few checkpoints to ensure I am getting a good deal. The first is that the dividend yield has to be higher than the inflation rate, and the second is earning yield has to be higher than the long term AAA bond plus the inflation rate. These standards grow and shrink based on the health of the market and with that fluctuation so does my standards for cheapness. It comes down to what the market is willing to give me at that moment. 

Investing this way will shrink your pool of potential investments to a number of around 75 stocks at any giving time, on the quality side and on the cheapness side to maybe 5- 20 stocks on any day, but so what? Would you rather hold a group of businesses that are mediocre and unstable just to meet a mystical standard of diversification? Or would you rather  hold 10 quality businesses that is kicking off 8% dividend growth and 9% earning growth, all while locking in an earning yield of 8%? 

Buy the best of the best, while getting them as cheaply as possible and let the nature of compounding take effect. 

If all of this seems like a lot of work, that's because it is - this is for the enterprising investor for the defensive investor I have another post for you here "Nature vs Nurture: Why I invest the way I do vs how I want you to invest."

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