Contents
Making your own Stock Portfolio
Ok, so you want to build your own stock portfolio. That’s great.
The first thing I want to point out is that stocks represent a fractional ownership in a business. Think of them as that. When you’re buying 10 Apple shares – you’re buying a fractional ownership Apple and becoming a part owner of the company, no matter how small. The distinction may seem irrelevant, but it helps stay in the right frame of mind. You are an owner in a business, and owners don’t just sell their company on any piece of good or bad news, they’re in it for the long haul – it’s an investment.
We’re not just trying to invest in the best businesses, but we’re also trying to get them at the best available prices. Since ‘best’ prices don’t often happen, we’re looking for a great price and patient for a excellent price. Remembering Warren Buffet’s ‘It’s better to own an excellent company at a fair price, than a fair company at an excellent price’.
The Philosophy (A Review)
This brings us into our first subject: Our investing philosophy. What is it?
- We are trying to invest in the best businesses. These are companies that have a durable competitive advantage allowing them to constantly earn above average rates of return over long periods of time.
- We are trying to get a good price. Meaning the stock is currently undervalued, and the more undervalued it is compared to its fair or intrinsic value, the better a price it is.
Again, when investing we are trying to find undervalued securities in high quality businesses growing at above average rates of return, and we want to hold these businesses for a long time, hopefully forever. Why is this the philosophy? Two reasons:
- Holding high quality businesses that generate high rates of return allows us to take full advantage of compounding, with benefits increasing over long holding periods.
- Undervalued securities provide a margin of safety. Having a margin of safety decreases your risk while increasing your reward. * (Defining Risk)
Compounding returns and Margin of safety are essential to long term success in the stock market. Study Warren Buffet and Charlie Munger and you will see that this is part of the strategy they use (They do much more than just this but you’re not going to be Warren Buffet, but luckily you don’t have to be – you can buy the Berkshire B shares.)
Breaking Down a Durable Competitive Advantage
Again, when choosing a company to invest in they need two things:
- A strong, durable competitive advantage (The result of this is a high-quality business generating consistent above average returns, allowing for price compounding at consistent above average returns)
- An attractive entry point – in other words by a company selling at a discount to its intrinsic value (This provides the margin of safety)
First let’s break down point #1 into two parts .
- A competitive advantage
- Durability
A competitive advantage is crucial to success because it allows for greater profits; a competitive advantage can exist in a few different ways:
- Through a cost advantage,
- A brand advantage,
- Or by strong barriers to entry
- And ideally a combination of the above.
Amazon or Walmart have a cost advantage through economies of scale. Simply put, purchases made at such large quantities allow them discounts which are then passed onto the consumer.
Nike or Coca-Cola have a brand advantage. You don’t want just any dark cola drink, you want the specific taste of Coca-Cola. The same way you don’t want just any brand of shoes, you want Nike’s. In both cases you trust and like the brand, and often know what you’re paying for.
Rogers or Telus have a strong barrier to entry. No one in Canada particularly likes Rogers or Telus, but still most all of us use them as a phone provider. Why? There is simply no one else to use. Same for flying in Canada, it’s either West Jet or Air Canada. Extremely expensive up front infrastructure costs make these businesses difficult to penetrate.
Now durability is exactly that, it addresses the question of how long can these businesses competitive advantages can continue? It’s hard to imagine a world where people don’t buy Coke or wear Nikes, but what about a business-like Netflix? It was first of its kind which allowed it to enjoy major success by completely changing an industry. But as Disney, Apple, Hulu, and other platforms grow will competition take away Netflix’s success? Almost certainly, but maybe not, time will tell. The barriers to entry aren’t strong enough, nor does it have a cost advantage. We’ll see how loyal people are to the brand – but I’m pretty sure they won’t be as loyal as they are to Nike or Coke.
To point number 1, there are good amount of high-quality business out there, but the price you pay for them matters and directly affects both the risk and return of your investment. There was a time when people thought you could just buy high quality businesses regardless of the price, the stocks were called the nifty fifty and see how that ends here (refer nifty fifty).
An Attractive Entry Point and What Makes a Good Price?
An attractive entry point exists when the market price (the stock price) is less than its actual worth. This actual worth is known as Intrinsic Value or the true value of the business, and it’s regardless of what the market price is. Now the exact intrinsic value of any decently complex company is unknown. There are too many moving parts and assumptions to be made in finding that number. What we’re trying to do is find companies that are undervalued by a large enough margin of safety so that we don’t have to be exactly right. As Benjamin Graham said, ‘You don’t need a scale to know a man is fat’.
Finding whether or not the company of our interest is undervalued or not can be simply calculated a couple of ways:
- The return on equity method
- Relative valuation (comparing the stock to its past self, between the stock and its industry, and between the stock and market). (This is a way to value, but you aren’t getting intrinsic value, rather you are seeing whether it is cheap compared to itself, the industry, and the market.)
Return on Equity Method:
I like this method because it’s simple and intuitive. Plus, it only works for companies that have a predictable earning stream, and only bears well for companies whose earnings have also been trending upwards. This eliminates a solid number of companies out there; and are the ones you would likely not want to invest in anyway.
First you begin with a company’s earnings yield, multiply it by its average earnings growth for a period of 10 years to get estimated earnings 10 years out. From there you take the average P/E over the past 10 years, apply the average to the earnings in year 10 to get an estimation of the price in year 10. Discount that price back to today to get an estimated return. This may sound a little confusing, and that’s ok, it’s much easier to show in an example, so click the link below to see me use this application on Google, The Gap, Netflix, and Costco. This analysis was done March 11, 2020 and so the prices reflect the date. You can compare to today to analyze the changes and how expectations are turning out.
A few examples are provided below.
Relative Valuation:
This compares the value of the asset to the value of another assets. Residential real estate is often priced this way, comparing the house you want to buy to houses in the area and to what it sold for in the past. For a stock there are three relative valuation methods you want to employ:
- Valuation of today compared to valuation of its past self. How cheap or expensive is it trading relative to its historical norm. Using a Valueline is an excellent way to do this quickly and gives a great snapshot of a company’s 10-year+ history. (What is a Valueline)
- Valuation compared to that of its industry. This would be comparing GM stock to Ford or Chrsyler stock, and not comparing it to Netflix or KraftHeinz. Industries have their own economic qualities that change the valuation of the business.
- Lastly you want to compare it to the market, usually the SPY for American companies. The SPY would have less risk than your individual stock pick so it must make up for that in return.
Application with Four Examples
Now that we know what companies to look for and whether or not they are trading at a price reasonable enough to provide a good margin of safety and return profile, let’s look at a few. I’ve picked out 4 companies to highlight some of the different circumstances we can run into. These companies are Google, The Gap, Netflix, and Costco.
Download Free Math Examples
Fill the form below to receive a free downloadable pdf of math examples to help you Build Your Own Stock Portfolio
How to pick stocks – Why the market provides stocks at a discount? + Patience and Discipline
This investing style I have highlighted above isn’t very exciting, and a lot of the time doing nothing is best thing you can do. You just simply hold. Now there are times to sell (Reasons to sell a stock) but most often then not the hardest part of this investing style is not selling out of boredom or panic, and not forcing buying opportunities. As an investor you can’t control the price the market provides, but everyday it offers a price, and everyday you watch hoping it offers you that great price – be patient. When does this happen? Three reasons:
- The market doesn’t understand the value
- There’s too much pessimism either from a bad recent piece of news, a bad quarterly/annual performance, or the general economic environment
- People need money and are selling stocks even if they don’t want to – a recession / depression
The time find to really great opportunities comes when a piece of bad news is being overreacted to leading to the stock being on sale. Look at price graph of Apple here (Apple Chart):
It has provided three separate instances in the last 10 years of 25% price drops all within a year’s time. Why? I can’t remember and neither can most people I’m sure, but there’s always some reason or story able to inspire fear, or optimism. And that’s exactly why people often sell fear, fear of the price dropping more and losing money. Look around and see the companies we use everyday, products and services the world not just wants, but needs. We all know Apple’s an enormously successful company whose products are now ingrained in our lives, but we all didn’t own Apple the last 10 years. Maybe we did in at a time and then sold (Like I did!). Too bad, $10,000 in Apple invested 10 years ago would be worth over $80,000 dollars today, while also paying over $1,000 a year in dividends.
The other great time to find opportunities is in a business downturn or a recession. Recessions cause job loss, they cause loss to asset prices, they cause debt issues, people and institutions sell assets to pay debt and spiral down we go. These moments in our history and future aren’t pretty. Your stock portfolio WILL be hurting, and so will the lives of some people around you. You can protect yourself if you’ve invested in high quality businesses that aren’t saddled by too much debt – these companies will get through the tough times and come out stronger in the end, maybe even losing some competitors along the way. It’s hard to purchase in such times, either because capital is tight or because everyone is scared. As they say, ‘Be greedy when others are fearful, and fearful when others are greedy.’
