I’m beating the market by 35% this year and this is how I did it.
For the past 6 years, I have been investing in the stock market. After reading The Intelligent Investor by Ben Graham just as I graduated from Business School, I was fascinated by the idea of being able to pick stocks that had the potential to outperform the market in the long run.
Luckily for me, the past 6 years as an investor have been great and I have managed to beat the market each year, including 2020 so far, with a 39.5% return (not counting dividends), against my own personal benchmark, the S&P500 which is up 4.92% YTD (as of August 19).
So how do I pick stocks?
First thing I’d like to make clear before starting is that I not always pick stocks that outperform the market on a single year. In fact, when I was just getting started I had a very diversified portfolio with over 30 different company stocks and had to learn the hard way that is best for me to allocate my cash in the ones that I believe the most. Now, I try to have no more than 10 to 15 active investments at the same time to make sure I force myself to select the ones with a higher upside.
The way I select companies to invest in is by making a decision that is sound in two aspects — qualitative and quantitative. So what does this mean and how do I make sure I get it right most of the time?
Quantitative aspects
When I speak about the quantitative aspects of a company is very important for me to know that I am paying a fair price for the business I am about to invest in. One of the key aspects that I discussed in a previous article “Mistakes you should avoid when investing in the stock market”, is that I like to think like an owner of the business I am investing in. Imagine you were to invest in a lemonade stand, even if the current founder of the lemonade stand sells you on the future of his venture and promises that in the next 3–5 years she will have 500 shops, each selling over a million dollars a year, if the current lemonade stand has sales of $100 dollars a year, you probably wouldn’t like to pay a valuation of $1 billion dollars.
So these are the things that I look for on the quantitative side of the business:
A Price-to-Earnings ratio that makes sense
Lately, I have seen companies like Tesla that are trading at a multiple of over 900x times their earnings 😱. That means for every dollar the company earns you are paying 900, which in my opinion is too expensive and risky.
The way I make sense of P/E ratios is by comparing the company I am analysing to the general market, their industry and similar companies. If the P/E ratio of a company is higher than the average, I try to justify the purchase of the issue through the qualitative aspects as well as other fundamentals of the company.
I used Tesla as an example earlier, a company that I felt was very attractive on the qualitative and future aspects and I bought shares at $190 in 2019; once the stock price started to climb as fast as it did I sold at about $1500, as I simply couldn’t justify holding a stock with such a discrepancy on its P/E ratio relative to that of the industry and general market. I have therefore missed about $400 of upside as of this writing, however, there is nothing that screams more of a bubble behaviour than that of Tesla stock and by selling I de-risk my portfolio from a potential loss.
Book Value
Many of my friends and peers that focus on a growth strategy hate when I bring up the book value, which is a data point that is mostly used by those focusing on a value strategy like myself.
The book value tells us the story in numbers of how much a business is worth once we repay all of its debt, and liquidate all tangible assets. I like to think of it as my insurance, by calculating the book value of a company, I know that in the worst-case scenario if the company I am investing in goes bankrupt tomorrow I will get a certain amount of cash per share I own.
I am personally comfortable with high price-to-book values, especially for solid tech companies like Amazon. However, if I come across a company that is trading below its book value is just a sign for me that I should take a closer look at its qualitative aspect and potentially invest a substantial amount on it.
There are currently over 1,400 companies trading below its book value, mostly in the energy and financial sectors due to the current volatility they have gone through (here). If you were looking for bargains, this could be a good place to start with 😉.
Can the company pay its debt?
Another crucial piece of information for my investment strategy is to know if the company is able to pay its short term debt with the revenues it generates and its operational costs.
A good place to start is by checking the current ratio of the company, which will give you an indication of how many times can the current liabilities (those that have to be liquidated in the next 12 months) can be met by using the current assets (cash and assets that can be turned into cash in the next 12 months).
To get a much better picture of whether or not the company will be able to repay the debt and not incur any operational issues like foreclosure, or repossession of their assets by the debt holders during a crisis, I go through the 10-K reports of the company (you can find this directly on the SEC website (here)). The 10-K reports give me a much better understanding of what the current assets are. Since inventory are counted in the current assets, I like to discount the inventory to its cost level (about 30–40% of retail price depending on the industry and company). I do the same with accounts receivable by discounting it to about 60%, giving a good margin for uncollectable accounts. As well as understanding what are “other current assets” and make sense of it on a case by case basis.
Personally, I feel comfortable investing in companies that I know can meet their current debt at least 2x times or more after operational costs.
Steady or increasing revenues and earnings🚀
Next, I want to make sure that the company I am investing in has a track record of either increasing revenues and earnings per share or at least being consistent.
The best place to get these numbers is on the income statement of the company you are analysing.
Here is Amazon as an example, a company I have been holding for the past 3 years as I was able to appreciate their growth on both revenues and EPS of more than 10% Year-over-Year 👀
One of the things you will notice in here too is that cost of revenues will tend to increase together with the actual revenues, this is more often in growth companies as they invest in different aspects to make sure revenues keep increasing, such as staff, research and development, equipment, etc. To get a better understanding of where the money is spent I take a look at their annual and quarterly reports.
If I see that a company has been having steady or growing results apart from one or two years, I make sure that I take a look at the respective annual reports to get an understanding of what caused those issues and then assess on the ability of the management team to make sure it does not happen again or they have enough cash reserves to take immediate action.
Dividends and payout ratio 🤑
“Never buy a stock that doesn’t pay a dividend” that’s the recommendation of Kevin O’Leary, and I’d say I somewhat agree with this.
Although I have invested and held stock of companies that do not pay a dividend like Amazon or AMD over the past 6 years. I always prefer to invest in companies that have a track of paying a dividend to shareholders for a couple of reasons:
- I get to reinvest dividends and let my portfolio compound on the interest generated by that income.
- It shows me as an investor that the company has steady cash flow and income that allows it to pay dividends, which is a great sign of the financial health of the company.
My second point is not always true, however, and that is why I like to make sure that payout ratio, which is the percentage of the earnings that are paid as a dividend, is not too high. Many could argue that if a company’s payout ratio is very high, the company is in fact neglecting the opportunity of reinvesting those earnings into research and development or new ventures that could generate even greater margins or earnings in the long term.
My personal strategy is to invest in a few companies that generate dividend income like AT&T with a 7% yield, and a mix of other growth and value companies that pay a lower yield but keep reinvesting in the own operations like Apple that has a payout ratio of almost 25%.
Qualitative aspects
Once I make sure that the company I am analysing meets the quantitative aspects, then I go into the qualitative aspects of the company. This section is really more an art than a science as it has to do a lot with what you think the future can hold for such a company. There is truly no way to predict what the future revenues of a company like Amazon or Tesla are going to be in the next 10 years but there are always many questions you can ask and answer to know that you are making a sound investment on a company that meets the quantitative aspects.
A great example is Blockbuster, a company that in the mid and late-90s had met much of the quantitative aspects I speak about in here, but an investor that focused on both the numbers and the story of the company could have seen that it was lacking in innovation and missing opportunities that eventually led to its bankruptcy in 2010.
To understand the context of the company I like to ask myself the following questions before I make an investment:
- Do I understand how the company operates and generates revenues, its strengths and weaknesses?
- Do I trust the management? Do they have a proven track record? Or is the entrepreneur a person that seems determined to innovate and disrupt an industry?
- Is the world heading towards the direction where the company is at the moment or heading towards? This will definitely help you avoid investments that look good on paper but are in fact dying.
- How easy would it be to replicate or better the current product or service the company is offering? And is the management team aware of this?
When I invested on Netflix, I made sure to try all different platforms like Hulu and Amazon Prime, as well as speaking directly to a friend who had the opportunity to work there. - Is this a product or a service that people will need in the next 10–15 years? Or is it a trend that will last 12 months? This question helped me avoid investing in GoPro and putting my money in Apple instead.
A final point I’d like to make is that even after making all of the analysis you can be wrong or have bad timing, and sometimes the stock you buy can drop more than you expect it very quickly. The way that I have managed to beat the market over the past 6 years is by staying true to my strategy, knowing that I have made my research and making sure I am right in my decision. But also, keeping a position of 10 to 20% of my total assets in cash, so in case of a market meltdown like that of this year, I am able to buy more shares of the company I was attracted to for a reason at a more attractive price than before.
This is a project on its very early stages. If you have any topics you would like me to cover, recommendations or if you simply liked the post, please feel free to get in touch with me directly — diego@konfidence.app or on Twitter
