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Here is how you win a game of chess. First, make sure all of your pieces are protected. There are exceptions to this rule but in general just make sure you aren’t leaving anything hanging, that is, in such a way that the opponent can take it without being forced to “pay” for it.
The next technique is the one that most beginners don’t know. Basically, accumulate tiny advantages throughout the game. An example is to have your rook on an open file, or to have a less exposed king than the other guy. Or to have a pawn that has no other pawns in front of it (so it can get to the other side more easily).
The idea is that while you are accumulating these isolated small advantages, your opponent realises you are crushing him when your advantage is overwhelming.
An investor can take the same view on his portfolio. What are examples of small advantages you can accumulate? Well, you can invest in a stock that correlates with a strong demographic trend. Then you know that even if you invest in a company with bad management you at least can hope to recover.
For instance, we know baby boomers are going to retire, get sick and die. I’m sorry, but it’s true. What stock corresponds to that investment? Basically, any company in the healthcare, pharmaceuticals and biotechnology sectors. Johnson & Johnson is a great example. The company trades at a forward price/earnings ratio of 14, 25 per cent return on equity and has beaten analysts’ estimates for the past four straight quarters. These are also tiny advantages we can accumulate: low p/e ratio, ability to beat analysts, high return on equity.
Another advantage I like to accumulate, and I’ve written about this before, is to have strong investors also own the stocks I own. For instance, if Warren Buffett owns a stock, I’m comfortable that he did the research to make an investment. Would I go so far as to say I don’t need to do any research? Well, yes. Although I would want to know where he bought the stock. For instance, I’m not interested in The Washington Post Company, which he bought in the early 1970s when it was trading for less than book. Because he has owned it for so long I’m sure he doesn’t sweat losing his profit. Also, he hasstated that the newspaper business is not so hot. So cross that off.
But now we can look at Johnson & Johnson again. In Mr Buffett’s last filing with the Securities and Exchange Commission, he just doubled down on the stock. He bought 24m shares, bringing his position to a tad over 48m shares worth $3bn. It’s his sixth largest position, after long-held positions such as Coca-Cola, American Express, Wells Fargo, Procter & Gamble and Moody’s, none of which he added to in the last quarter. So do we have to do research on Johnson & Johnson? Probably not. But let’s keep accumulating some advantages.
For instance, we have demographics behind us, we have low p/e ratios, good return on equity and so forth, and now we have Mr Buffett. How about dividends? I like to make cash while I’m waiting for a stock to double. The more cash you make, the less risk you have on the table. Johnson & Johnson has a 2.7 per cent dividend. Solid. Want to throw in one more tiny advantage? It has increased its dividend every year for the past 17 years. We’re wasting time if we do more research on this stock.
Another tiny advantage I like to have is to own companies that have a lot of cash in the bank and no debt. This is an obvious advantage but it’s amazing how many people ignore it. For instance, don’t own a biotech stock in Phase II trials with no revenues that has only $30m in cash in the bank. How come? Because it will run out of cash before Phase III finishes and before that happens it will do a dilutive financing. The stock may or may not work out. Who knows? But you’ve just accumulated a disadvantage when you own one of these.
Instead, look for a stock such as United Online, with $168m cash in the bank, no debt and $153m in positive earnings before interest, taxes, depreciation and amortisation. It also happens to own one of the fastest growing social networks, Classmates.com, and super hedge fund Renaissance Technologies owns the stock. And it pays a 4.9 per cent dividend.
I was going to tie this all into poker but space is running out. There are two sayings, though, that apply to investing. First, “those who chase straights or flushes go home on Greyhound buses”. In other words, don’t buy a stock hoping for a good earnings report as the only way you’re going to win on the investment. And “if you can’t spot the fish at the table, then it’s you”. There are a lot of sharks at the table: hedge funds, mutual funds, day traders, Mr Buffett, and so forth. But if you accumulate tiny advantages you have a better chance of winning.