Are you here to make money? Or are you here just to play the game?
This important question comes from Adam Smith’s book The Money Game. It was published in 1967—before The Age of Paper Wealth even began.
The Age of Paper Wealth refers to the time from 1982 to 2022. It was a time when interest rates only went down… and stocks only went up.
As we discussed yesterday, investing was easy in that climate. All you had to do was buy some growth stocks and then forget about them. If you checked back in on your account five or ten years later, it was guaranteed to be up.
Those days are over.
And if you’re here to make money – not simply play the game – there are some important moves you need to make.
Look, investing is simple. If you do it right.
I’ve talked to many people who see the stock market as a casino. Of those, many think it’s a rigged game.
And I agree 100%… if you ignore the factors that determine the outcome of any single investment.
I know plenty of people who buy stocks based on “tips” or “intel”.
They’ve heard that a new law or regulation is coming that will catapult a small company’s shares higher.
Or they’ve heard that a company is about to announce a new product that’s going to be revolutionary, thus now’s the time to get in.
Or they’ve heard that some little company is about to ink a major deal with Apple or another giant company, and that’s going to send the stock soaring.
If that’s your framework, you’re not investing—you’re gambling.
Then there’s the other side of the coin…
I also know plenty of people who simply herd their money into their 401k funds because they are “diversified”. Those same folks might venture out into the world of exchange traded funds (ETFs) as well, for the same reason.
That’s also gambling… because you have no control over what those funds buy, sell, and hold. And the fund managers make their money regardless of what their performance looks like.
So what are the factors that determine the outcome of any stock investment?
Time, compounding, and valuation. That’s all we need to focus on.
When it comes to the first – time – the question we need to answer is this: How long can we safely hold a given stock?
Of course, there’s no simple answer to this question. It requires some deep analysis of the company and the industry it’s in, as well as educated projections regarding macroeconomic trends.
But that’s the business we’re in. That’s our job. And we love doing it.
The second factor is compounding.
Apparently Einstein said that compound interest is the eighth wonder of the world. I don’t know if he actually said that. But the second part of the quote attributed to him is correct:
He who understands it (compound interest), earns it. He who doesn’t… pays it.
Compound interest refers to earning interest on your interest over time. Your money makes money… and then that new money makes more money. And so it goes…
When it comes to stocks, the question we need to ask is: How much can we expect a stock to compound each year over our safe holding period?
Well, it all comes down to the dividend yield.
The key is to anchor our portfolio with stocks that pay a strong dividend – and will continue to pay a strong dividend for years to come. Then we have our broker automatically reinvest those dividends right back into the stock for us. At least for as long as the stock is fairly valued.
This grows the number of shares we own every quarter… which increases our dividends… which grows our share count even faster. That’s how we earn compound interest.
But let’s not forget the third factor. Valuation. It’s the most important.
For every investment we make, we must ask: At what valuation can I safely buy this stock?
Notice I didn’t say price. A stock’s share price is meaningless. It doesn’t convey any useful information to us.
Think of it this way – there are “cheap” stocks priced at over $200 per share today. Those stocks will do well going forward. At the same time, there are “expensive” stocks priced under $10 per share today. They will perform poorly going forward.
Don’t be misled by share price. It’s the valuation that matters.
What’s the stock’s enterprise value relative to the company’s sales? How about its earnings? And how does that valuation compare to the key performance metrics for companies in that industry?
If we build a portfolio of companies that will safely compound for us for years, maybe decades to come… And if we only buy these companies when they are trading at attractive valuations, we’ll wind up with a bulletproof portfolio that increases in value every year—regardless of what else happens in the world.
Simple as that.
But I know I haven’t fulfilled on my promise from yesterday. I said that if you want to make money in the market, you’ll need to overhaul your portfolio. How do you do that?
I’m glad you asked…
Bulletproof Your Money
I’m writing this on October 26, 2023. This isn’t evergreen advice… because those three factors we mentioned earlier are constantly changing.
But as of today, there are five “buckets” you need to move your money into. We can think of these as our investment themes. They are as follows:
- Reserve Assets
- World-Class Insurance
- Energy Renaissance
- Gold Equities
- Consumer Goods Inflation Hedges
If we only invest in these five core themes, our portfolio will do very well in the years to come.
But remember, we must do our homework before investing in any stock. And most importantly, we can only buy at attractive valuations. That’s key.
We’ll break down each of these asset classes next week.
-Joe Withrow