Resolutions: Of Chocolate and Lemonade

Did you know that the fourth highest day of chocolate consumption is January 4th? Yes, trailing only Easter, the Christmas season and Valentine’s Day, that fourth day of every new year marks the collapse of our dreaded new year’s resolutions. You know the routine, “I’m gonna lose some weight, eat less chocolate, stop smoking and drinking and commit some time to getting my investment efforts in focus.”

Be It Resolved…

But four days? I’ll plead guilty to participating in this annual slaughter of good intentions. “No really, I’ll spend more time every day at the health club, just as soon as I can remember how to get there, Dear.”

A funny thing happened on the way to this year’s moment of fleeting resolution. I finally made one that I can feel pretty good about breaking. I pledged that this year I’d refrain from making resolutions. True to form, I began breaking this non-resolution immediately. I haven’t had a cup of coffee yet this year and I’ll confess that this “simply happened.” We’ve closed all of our fugitive investment accounts, consolidating them in a place that we can monitor and maintain using the philosophies and methods you’ll find at Manifest Investing. We’ll be continuing and redoubling our efforts to help groups of employees understand and optimize their defined contribution plans.

If you’re fairly new to investing or new to the concepts presented at Manifest Investing / Expecting Alpha, I want to take a moment and extend an extra special welcome to you. Becoming a committed, patient and strategic long-term investor is probably the most exciting thing that you can do about your future and the well-being of those you care about the most.

Natural Fear

“But I don’t understand all of this investing stuff?” I save my greatest fears for the things I understand the least. I suspect that you have some of the same feelings about uncertainty. If you’re feeling a bit overwhelmed, I want to share something one of my colleagues taught me a long time ago.

She’d been participating in a series of online discussions about stock analysis and long-term investing. She admitted that the avalanche of buzzwords and jargon was making it difficult for her to keep up. But she also shared that she simply kept a file of notes and index cards. Whenever somebody talked about something she didn’t understand, she’d file it. Then she’d periodically revisit the folder to see if there were any cards she could throw away. As time passed, she emptied the folder and discovered a peaceful confidence with her investment decisions.

The rest of the story? This lady ultimately went on to write a column on investing for a magazine!

This approach, or something similar, might work for you. But don’t make any resolutions about it!

An Antidote to the Fear

My experience with my first stock purchase is etched in stone in my memory. With CNBC blaring, I’d taken the afternoon off from work to use my Schwab account for the first time. I’d read some magazine articles and was convinced that Waste Management was destined for greatness. I set some steaks out for the celebration of our arrival as individual investors when my spouse got home from work. With sweaty palms and chronic “stage fright” I finally held on to the receiver long enough to give my purchase instructions to the broker. I hung up and lost consciousness. I recovered to watch the last fifteen minutes of ticker tape for the day. WMX 35… WMX 34 1/8… WMX 34…WMX 32 3/4… WMX 31 1/2. I lost consciousness again. My carefully considered investment had lost ten percent of its value in 15 minutes on this suddenly gloomy Friday afternoon. My wife came home, put the steaks in the freezer, and got out some hot dogs for dinner.

The fear is natural. But there are some answers. Conquering the fear and maintaining the patience and commitment to virtually anything is usually easier when you do it with friends.

Manifest Investing is approaching its 8th birthday. We support the promise and potential of investment clubs for people who want to embark on a life long journey of successful investing. Investment clubs are educational vehicles. Our community of long-term investors is unequaled and a considerable resource for people trying to remove the mystery and become successful long-term investors. If you’re not a member of this community, you should be.

Five Things Investors Need to Understand

Your objective as a serious long-term investor is actually pretty simple. You want to do well. Your version of “how well” is up to you and you’ll learn about the importance of sleeping at night as you continue your investing journey. I believe that reasonable expectations are important. I do not expect to achieve 40% returns year after year. I do expect the returns from my investments to range from one-year drops of 20-30% to single year gains of as much as 50%.

But over the long term, I expect my returns to slightly better (3-5%) than the general stock market. The accompanying figure shows the returns for any given year since 1941. We see that most years, the annual result ends up between 0-30%. In fact, the average annual return for stocks has been approximately 10%. Do you see the “bell curve?”

Annual Returns for the Modern Stock Market. The modern stock market is the period following the reforms of 1932-33 and 1940. Take a look at the returns for the years starting with 1941, a uniquely bad year and 1945, a uniquely good year. Think about world conditions at the time. Note the ebb and flow as the decades roll by. Notice how unprecedented the late 1990s were, as consecutive years all landed to the right. The frustration of 2000-2002 gave way to better times in 2003 and 2004. Sources: Manifest Investing LLC, Ibbotson Associates.

The annualized total return for our Tin Cup demonstration portfolio since 1995 stands at 18.7% during a period when the stock market has advanced 6.4% per year. I believe that aiming for returns that are 3-5 percentage points higher than the general stock market has a decent chance of achieving that goal.  Not every year will be a bed of roses but we spend a lot more energy focusing on the results on the right than the left — all the while remaining focused on the windshield and NOT the rear view mirror when it comes to designing and managing our portfolios.

The first thing we need to understand (and have) is an objective, a target total return. Most people understand annual returns. If you’re offered a certificate of deposit with a 4% return or one with an 8% return with identical terms, most of us would choose the higher return.

Scores of investment clubs achieve long-term annualized returns that exceed market benchmarks. We’ll share details and lessons learned from successful portfolios and mutual funds in future articles. The point is, it is possible to achieve market-leading returns over the long run.

Taking aim at that long-term result requires that we understand expectations for the individual investments that comprise our portfolios. We need to build portfolios with enough return expectations to achieve the objective. Much like caring for a garden, this is a never-ending vigil. We also need to understand the differences between weeds and desired plants. This is the role understanding investment grade, or quality, plays in our efforts.

Using the methods discussed here, the expected returns and quality are built from three characteristics: projected sales growth, profitability and value. Think G-P-V.

Despite all of the buzzwords, it really boils down to common sense. Our son and daughter and our nieces and nephews used to build a lemonade stand while visiting my parent’s house. Mom and Dad lived on a golf course and the stand sat in the middle of some shady evergreen trees. Golfers do get thirsty. It was a good business model. Needless to say, the enterprise was pretty profitable. What was the business worth?

That depends. How much did the lemonade mix cost? What did these young entrepreneurs charge and how much was left after reimbursing my mother? Would it have made sense to launch another location? An income statement is no more complicated than that. How much more will the golfers drink? What profits will be left after paying all the bills?

Common stock investors own a piece of the business, a stake in the profits. A stock price is nothing more than the most recent result of a price negotiation. It doesn’t always resemble what the business is worth. That’s where the value (or valuation) comes in. We’ll take a closer look at valuation next month and attempt to demystify this challenging concept a bit. For now, think Growth-Profitability-Valuation and that this leads to an understanding of quality and expected returns. This is the core of our MANIFEST method. “Less fear.”

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