Investing in stocks is a simple game.
That was the subject of yesterday’s letter. And the reason is simple. There are only three variables that control the outcome of any stock investment. This is true regardless of the economic climate.
The first variable is time. How long will we be able to 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 for certain companies, it’s not that difficult. Take a capital-efficient consumer goods company like Hershey or Domino’s Pizza, for example.
Do you think people will still be buying cheap chocolate loaded with sugar thirty years from now? Do you think they’ll be buying cheap pizzas delivered on time right to their door for decades to come?
I do. Therefore we could safely hold those companies for at least thirty years… if the other two variables line up for us.
And that brings us to the second variable. It relates to 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 only invest in 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.
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 about the third variable. It’s the most important one.
Valuation. 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. More to come tomorrow…
-Joe Withrow
P.S. Speaking of what’s happening in the world… it’s getting interesting out there. And dangerous.
For a breakdown of the key macroeconomic trends playing out right now, and who the major players are, check out my new book Beyond the Nest Egg. It’s starting to gain a little traction on Amazon.
You can find it right here: https://www.amazon.com/Beyond-Nest-Egg-Financially-Independent-ebook/dp/B0CG7VYRV7/