The issue of successful stock market investment affects us all. Even if we are not directly engaged in the industry, all of us will need some form of pension to fund our retirement. Whether we like it or not most of our retirement funds will find their way into the financial markets. For this very reason, the issue of pensions has moved politically centre stage, in particular the investment strategies used to direct pension funds. Due to mismanagement, mainly over the last decade, many retirement portfolios have become under-funded at best, or, at worst, totally bust. This situation is a direct result of the managed funds having been speculated rather than invested. Many cynics will say that the whole investment environment today has more of the characteristics of a casino than of a professional market of equities and, therefore, they doubt that one can ever achieve a faithful and fair return on capital. However, this view is erroneous. This essay sets out to explain how to achieve superior stock market investment returns through a simple yet powerful investment rule: “the rule of 72”. This rule is based on investment and not speculation yet if you faithfully apply it your returns, over time, will be worthwhile. Many believe that such degree of return is only possible through “speculative activity”. They are wrong and I will explain.
Benjamin Graham, the father of security analysis, and mentor of Warren Buffett, long believed in the stock market as a means to achieve financial freedom. The wealth he accumulated and the school of successful investment gurus he educated are testament to his insight and genius. The key to his formula has always been one simple concept: VALUE. His central message never changed and in a financial community which bores easily, his conservative investment style became "classical" and then "old fashioned". Graham ultimately derided the fads and trends that engulfed Wall Street and he eventually gave up trading and managing funds. However, his "baton" of value was spectacularly taken up by his acolyte, Warren Buffett, who went on to become the most successful investor of all time.
Buffett, like Graham, believes the policy of investing does not require high qualities of insight or forethought, as long as some simple rules are applied. In essence these simple rules are:
- Safety of Capital
- Adequacy of Return
An operation that does not seek both of the above is not an investment but a speculation.
Now in today's complex, volatile, media-driven and fast-moving market environment how does one actually apply these simple rules? The essential thing to realise is that when you buy an equity, you are purchasing part of a business. Investment is most intelligent when it is most business like. For my part, the best way to achieve this business-like goal is to focus on price, and through systematic analysis of this factor, the grail of value will be discovered.
At Wealthbuilder, for pension purposes, we educate clients in how to review up to three thousand stocks every quarter. Using a number of filters, equity prospects are identified and compiled into watch lists. Then, through the use of basic technical analysis, appropriate buy-in and sell-out points are pinpointed. The main criteria that are used to filter these stocks are:
- Financial Strength
- Earnings Growth
- Business Model Strength & Sustainability
- Dividend Yield
- Dividend Growth
- Return On Capital
- Price/Earnings Ratio
Of these seven elements, earnings growth and dividend yield are the most important. Why?
The big driver of investment returns over time is not figuring out which sector is going to do best, or which country will surpass the rest, or what investment style will be in vogue, or which consumer group will prevail. No, the biggest driver is: EARNINGS GROWTH AND INVESTMENT INCOME RECEIVED AND RE-INVESTED. The facts are that with dividend yielding stocks, over a rolling twenty-year period, a significant element of your return will be based on income received. However, in the main, the major part of your gains will come from earning growth because the fundamental axiom of financial dogma is: “where earning go share price will eventually follow”.
Thus it is crucial to your investment success that you find those great companies that give great yet sustainable returns (earning growth plus good dividends) over the long term. The profile of such profit generating institutions can only come from companies in large markets with proven products or services, areas such as: financial services, consumer staples, healthcare, energy and insurance.
Our ideal growth targets?
Earnings growth in the 12% per annum range is our ideal goal. Add to this a dividend yield of 2% and you get our combined investment objective of 14% growth per annum. In summary our investment formula is as follows:
Financially Strong Businesses + Large Growing Sustainable Markets +
Growing Earnings + Good Dividend Yield + Good Dividend Growth =
The Rule of 72
Why do we look for 14% growth? Well to understand this let me now introduce the rule of 72. The "Rule of 72” is a simplified way to determine how many years an investment will take to double, given a set annual rate of interest. Thus by dividing 72 by the annual rate of return, investors can get a rough estimate of how long it will take for the initial investment to “double” itself.
For example, the rule of 72 states that $1 invested at 10% would take 7.2 years to turn into $2 (72/10 = 7.2).
Thus our target annual rate of return of 14% requires 5 years for “doublings” to take effect. (See example below using approximations):
Year 1. 1000 X 1.14 = 1140
Year 2. 1140 X 1.14 = 1300
Year 3. 1300 X 1.14 = 1482
Year 4. 1482 X 1.14 = 1689
Year 5. 1689 X 1.14 = 1926
The average “pension investment” cycle is 20 years, therefore if you focus on the annual investment target of 14% you can get 4 “doublings” of your initial investment over the 20 year period. Thus through the “magic” of compounding a 100,000.00 dollar investment grows into a handsome pension fund of 1.6 million dollars after 4 such “doublings”.
Year 1-5. 100,000.00 X 2 = 200,000.00
Year 6-10. 200,000.00 X 2 = 400,000.00
Year 11-15. 400,000.00 X 2 = 800,000.00
Year 16-20. 800,000.00 X 2 = 1,600,000.00
We believe such returns are necessary because over the next 20 years, according, to John Williams of ShadowStats.Com, inflation will not be a benign 1-2% (see CPI rate) but 7-9% (see SGS rate) due to the ongoing Quantitative Easing policies being executed in the USA, Latin America, Canada, Japan, Britain and the EU.
Unless investors have an aggressive strategy to find and stay invested in superior companies giving annual growth rates in our target range their “life-styles” are going to be significantly altered by inflation going forward. Using the ShadowStats above, when we apply the rule of 72 to an annual 7% inflation rate we can reasonably estimate that over the next 20 years there will be two doublings of general price levels (72 divided by 7 is approximately 10. 20 years divided by 10 is 2). This will have a cathartic effect on future society. To be fore-warned is to be fore-armed. It is our opinion that the best way to protect yourself against this monetary crisis is to become a smart investor. Time is of the essence.
Despite appearing to be a complex matter, the path to investment success is quite simple, as pointed out by Graham all those years ago. The financial achievements of his students: Warren Buffett, Charlie Munger, Ed Anderson, Bill Ryane, Rick Guerin and Stan Perlmeter, are testament to the enduring power of his investment philosophy. By applying our earnings growth and dividend investment policy the average investor, using discipline and patience, has within his or her grasp the power formula to earn superior returns in the stock market and thereby win for themselves and their families financial freedom and independence.
Charts courtesy of ShadowStats.Com.
© Christopher M. Quigley 14th. November 2013 Wealthbuilder.ie