Where I disagree with Buffett and Munger

(PS: this is not a click-bait, I do indeed disagree with Buffett and Munger 🙂 )

Dear Readers,

It has been very difficult to make time to blog in the recent few weeks. However, I am hopeful that things should improve on that front and should be able to make some time towards my passion for writing on my favorite subject i.e. dividend growth investing.

I was thinking of what would be a good topic to write about for my next post, and after a lot of thought, I decided to pick a rather controversial topic: the one about diversification vs concentration in a portfolio. Simply put, if you are investing your capital in a few businesses, should you focus your bets on a few stocks that you understand very well OR should you diversify your investments across a few sectors with the knowledge that you may not necessarily be an expert on each and every one of them.

This has been a long standing debate in the world of investing. And like with every debate on investing, it too evokes strong opinions. I happened to be discussing this subject with a friend of mine and while he and I agreed that diversification is the way to go for the average retail investor, he cited how two of the most famous and successful investors of our time, Warren Buffett and Charlie Munger, were against diversification.

So I decided to do some digging and found the following video from the 1996 Annual Berkshire Hathaway meeting, where one the shareholders puts this very question to Buffett and Munger. Check out the video below:

To quote Buffett on this (pay special attention to that statement in bold, we will revisit it soon):

But I can assure you that I would rather pick — if I had to bet the next 30 years on the fortunes of my family that would be dependent upon the income from a given group of businesses, I would rather pick three businesses from those we own than own a diversified group of 50.

So clearly Buffett does not believe in diversification and instead recommends a concentrated portfolio consisting of businesses that one understands very well.

I am going to take a contrarian stance and disagree with Buffett here from the perspective of the average investor. In my humble opinion, this is terrible advice for the average retail investor. Now I know what you might be thinking: what do I know in comparison to Buffett, one of the greatest investors of all time. Sure, I may not be as successful as Buffett, but what I do understand very well are my limitations as a regular Joe investor. Hear me out here for a second and then you can make up your mind.

I contend that how you and I understand and evaluate businesses is drastically different from how Buffett and Munger understand businesses. So when they claim that they understand a particular business well, it is NOT the same as my claim that I understand a business well. We both may understand a specific business in our own limited capacities. In fact, their knowledge base is so profound that their knowledge will vastly outweigh mine.

For these reasons, it makes very little sense for Buffett and Munger to diversify. Similarly, it makes very little sense for the average retail investor to NOT diversify.

To drive home this point further, fast forward to the 2021 Annual Berkshire Hathaway meeting. Here is a video for your reference ( between 13:34 and 16:54). In the meeting, Buffett shares a list of the top 20 companies (by market cap) in 2021 and asks his audience to guess how many of these companies figured on a similar list back in 1989. He then shares the second list with the audience from the year 1989. Here are the snapshots of the two lists for your reference:

Notice that none of the companies from the 1989 list are on the 2021 list. In fact, you may have not even heard of several of the companies in the 1989 list.

So, following Buffett’s advice, if I as a regular retail investor, were to simply invest in three businesses that I *thought* I knew well in 1989, imagine how that would have turned out for me? To make matters even worse, I looked at a similar list for 2000, nearly ten years after 1989. You can check out the list here. Once again, apart from General Electric and Exxon (prior to its merger with Mobil Corp.), the top 10 list looks drastically different.

Interestingly, in the 2021 Berkshire Hathaway meeting, Buffett goes on the advocate for low-cost index funds.

One thing it shows incidentally is that it’s a great argument for index funds is that the main thing to do is to be aboard the ship. A ship. They were all going to a better promised land, you just have to know which one was the one that necessarily get on. But you couldn’t help but do well. If you just had a diversified group of equities, US equities, that would be my preference, but to hold over a 30 year period.

I recommend the S&P 500 index fund, and have for a long, long time, to people. And I’ve never recommended Berkshire to anybody, because I don’t want people to buy it, because they think I’m tipping them into something I’d never. No matter what it was selling for. And I’ve made it public. On my death, there’s a fund for my then-widow, and 90% will go into an S&P 500 index fund, and 10% in treasury bills.I like Berkshire, but I think that a person who doesn’t know anything about stocks at all, and doesn’t have any special feelings about Berkshire, I think they ought to buy the S&P 500 index.

So did Buffett change his stance? Well, I am not sure. But I would agree with the Buffett of 2021, in that index funds are the perfect solution for someone who does not know what he/she does not know about stocks and businesses.

Let me know your thoughts below. Regardless of whether you agree or disagree with me, I would like to hear your opinions on the subject.

The Savings Rate – Revisited

My dear loyal readers,

I sincerely value your readership and appreciate your patience over the last few weeks in sticking with my blog updates. I am hoping that I have not lost you. Life has been crazy busy over the last several weeks. As I stated in my previous post, I am going through an fairly significant change in my professional life which has been consuming a lot of my free time. I would finally like to talk about this in this post.

Before getting started, I wanted to take you back to the topic of “Savings Rate” which I have also talked about previously on this blog.

A simple equation to look at your savings is as follows:

Savings = Income Generated – Expenses

Our objective is to improve the savings rate to the best extent possible, because higher the savings, the more capital we have to invest into our own future. For dividend growth investing to work as a strategy, it is important to ensure that we are investing as much capital as we possibly can atleast during the accumulation phase of our investing journey.

None of this should be overly controversial as the subject of improving the savings rate is pretty critical to the success of ANY investing strategy, let alone dividend growth investing.

The part of the equation that does not get as much attention as it should is the “Increasing Income” part. Since we are so hyper-focused on the “reducing expenses” part of the equation, we generally ignore the aspect of getting better at our day jobs and “coast” through it. Some of this is due to the relative comfort of our job, we understand it pretty well, why push ourselves in the quest for something better? Is it really worth it?

In my case, I saw a couple of interesting dynamics that prompted me to seriously ponder over this question. The rising inflation was one of these factors. At the time of writing this, we are seeing record-high levels of inflation and it is unclear how long this situation will last. The other dynamic was a question about my employer’s profitability in the years to come. As an investor, I am now used to reading through financial statements and questioning aspects of the businesses that I am invested in. I used some of these learnings to study the financial statements of my own employer. The exercise revealed some interesting insights. I was able to make reasonable approximations about the company’s long-term profitability and make reasonable guesses about how long it would take me to reach my financial goals if I would stick with this employer. It also dawned on me that while things are great with my employer at present, there is only so much I could do to boost my pay beyond a certain level. Ultimately, this exercise prompted me to start considering other options.

Interviewing in my area of expertise (i.e. tech sector) is incredibly hard and requires months of arduous preparation. This is because the interview process itself is fundamentally broken thanks to the FAANG (Facebook/Meta, Apple, Amazon, Netflix, Google) style of companies. These companies have tailored the software engineering interviews to include questions surrounding topics that an engineer would have typically studied back in graduate school. These questions, while academically interesting, have arguably little practical relevance. Unfortunately, the rest of the tech industry has been so enamored by these FAANG companies that they have replicated the interview process as well. It can be mind-numbingly stupid at times, but there is nothing much anybody can do about this.

Anyhow, the mere thought of preparing for interviews can be demotivating by itself. In my case though, I had to look past this and focus on my larger goals. So I prepared….juggling my responsibilities between a full-time job, my family responsibilities and using every little free time available to prepare.

After interviewing with several potential employers, I landed up with offers from a handful of them. Apart from evaluating the offers themselves, I studied each employer’s history by looking through their annual SEC filings, reading up about the management itself and factoring those into my decision making. This is something that I never did previously in my career. I would mostly look at the role itself, look at the offer in isolation, rely on the recent media news about the company and just take a blind leap of faith about the health of the company. My education as investor has forced me to research these other aspects of a potential future employer and use that to make a decision.

In the end, I am happy that I went through this process. Change is incredibly hard to accept especially as one progresses through life. But sometimes it is important to take a step back, analyze and make a difficult decision. At this point, I have no idea if my decision is right or not. But the decision is based on a logical premise, and that is all that is in my control.

Generating Passive Income using Options Trading

I have been sitting on the sidelines of option trading for a while, researching the subject and educating myself and seeing how best to use this as a medium to generate additional passive income to facilitate my dividend portfolio. I have finally decided to take the plunge after crafting a strategy that would be ideal for my situation.

There is a LOT of information out on the interweb explaining the basic terms of option trading. Unfortunately, while most of these instructions explain the basics well, they do not do a great job of elaborating the risks where such trades could go wrong. For the beginner atleast, this discussion starts to get too complicated far too quickly. In general, stock trading when not understood correctly can be a recipe for disaster. But when it comes to options, that risk is multiplied by a sizeable factor.

So what the heck is an “option”?

The textbook definition of an option is this: it is a contract that gives the buyer of the contract the opportunity to buy or sell an underlying asset at a predetermined price within a certain period of time.

There are several terms and concepts here that warrant further clarification.

  • What is an underlying asset? In our case, stocks for a particular company.
  • Since the contract is valid for only a certain period of time, each contract is associated with an expiration date.
  • The predetermined price for the contract is typically called as the strike price.
  • Notice that the definition says “gives the buyer the opportunity…”. So the buyer can choose to NOT buy the underlying asset, if the current stock price is not conducive to the trade. More on this in a second.
  • An option contract is typically defined in terms of 100s of shares i.e. 1 contract = 100 shares.

There are typically two types of options that are available for trade:

  • Call Option: This option gives the buyer an opportunity to buy an underlying asset at a strike price before expiration date.
  • Put Option: This option gives the buyer an opportunity to sell an underlying asset at a strike price before expiration date.

Call Options – Better Explained

Call options can be better understood using the following example. Consider that you are looking to a buy a house. You find a house that you like, you like its listed price and you decide to enter into a contract with the seller by providing a specific down payment (a specific non-refundable percentage of the list price). The down-payment made as a part of this contract now provides you an opportunity to buy the house at a predetermined price before the contract expires (lets assume the contract was valid for a month). During this contract period, one of two scenarios is likely to happen: you will eventually buy the house after the contract expires OR you will back out of the contract and not decide to buy the house for whatever reason. For instance, you, the buyer find out that the house has some structural issues in the foundation and you decide that you do NOT want to purchase this house anymore. You back-out of the contract. The seller gets to keep the down-payment portion. On the flip side, if you are happy with the house and the contract period expires, you will eventually buy the house at the agreed upon price and you now own the house.

The call option is very similar to the above example. The down-payment, in this case, is what is commonly referred to as the option premium. If the buyer of the option contract notices that the price of the underlying asset (i.e. the current stock price) has increased beyond the strike price, the buyer can exercise the option and buy the shares. Why? Because he is now getting those shares at a cheaper price through this contract than what the market has to offer. However, if the stock price happens to remain below the strike price during the contract period, the buyer would never exercise the option (after all why would he want to pay a higher price for the stock if he can buy it cheaper at the market price). In this case, the option contract expires worthless. The seller of the call option contract gets to keep the premium regardless of what happens with the option contract. If the first scenario plays out, the contract is said to be In-The-Money (aka ITM) i.e. the value of the stock per the option contract is below the current market value of the stock. If the second scenario plays out, the contract is said to be Out-of-the-Money (aka OTM) i.e. the value of the stock per the option contract is above the current market value of the stock.

Put Options – Better Explained

A Put option can be better understood using the following analogy/example. Lets assume you own a share of Apple (ticker: AAPL). Lets assume the stock is currently trading at $170. Due to some recent news and your own research, you have reason to believe that AAPL’s iPhone production is going to be severely impacted in the next few years that would cause a huge dent in their earnings. You are expecting the stock price to tank shortly. You would like to “buy some insurance” such that if such an event were to happen within the next month, you would be able to sell the company at a predetermined price, say $150, and walk away, thus minimizing your overall loss.

In essence, the “insurance” you are buying is the put option contract. As a part of buying the insurance, you are paying a premium to the seller thus giving you the opportunity to sell the shares of this company if the stock tanks. If the stock were to drop below your predetermined strike price ($150 from the above example) before the expiration data, you get to exercise the contract and sell your shares at higher price compared to the market value of the share (ITM). If, on the other hand, the stock never tanks below $150, you will never sell your shares and the contract would expire worthless (OTM). In either case, the seller gets to keep the premium for providing you this “insurance”.

Option Metrics

Time is a huge factor in determining the option premium for any option contract. And based on time, there are some option metrics/parameters that investors can use to determine the risks associated with any given option contract. These are typically denoted using greek alphabets and are popularly referred to as “Option Greeks”. There is a LOT that can be said about each of these, but I’ll focus on the salient ones:

  • Delta: is the rate of change of the option’s price for every $1 change in the underlying asset’s stock price. A quick use of this parameter is to determine the probability of the option contract will expire ITM.
  • Theta: This represents the amount by which the option’s price would decrease as the time to expiration approaches.
  • Gamma: represents the rate of change of delta w.r.t changes in the underlying asset’s stock price.
  • Sigma: Or more commonly referred to as “Implied Volatility” (IV), in addition to delta, is perhaps one of the most important Greeks for option traders to examine. This represents a probabilistic estimation of the market’s forecast of the movement in the underlying asset’s stock price. It can also be viewed as a gauge to estimating market risk. A higher sigma/IV would typically result in a higher option premium.

Option trading for the beginner

If you are reached this far and are still with me, please pat yourself on the back! You are now armed with a basic understanding of options. At this point there are several interesting paths forward.

In my case, my next step was to determine how to use this knowledge and make it fit into my overall investment goals. There are several strategies available to option traders, some more complicated than the others, and suitable to different investment styles. Two of the these strategies that are especially popular amongst beginners and that seemed to resonate with me were: covered calls and cash-secured puts.

I arrived at the following conclusions w.r.t these strategies and option trading in general:

  • As a beginner, it is far easier to sell options. Let me elaborate on this through the next two bullet items.
  • If you own atleast 100 shares of a particular security, selling covered call options is a great strategy if you are okay with selling a stock at a price where you believe the stock is overvalued. Why? Well, you believe that the stock is overvalued at a specific price based on your research and you are okay with selling the stock at that price. As opposed to selling x100 shares through your broker through a regular stock trade, by using a covered call strategy to wait for a your desired sell price, you get paid an option premium for waiting. If the option expires worthless, you continue to hold your 100 shares and earn a premium.
  • If you want to own atleast 100 shares of a particular security at a specific price, and you have some cash available to you, enough to cover the cost of 100 shares * specified price, selling cash-secured puts options is an ideal strategy in such a situation. Why? You are interested in opening a position in a particular security, but what the market is offering you is more expensive than your desired buy price. So you wait. But waiting as a part of a cash-secured put option strategy allows you to earn a premium. If the stock price drops and reaches your target buy price, you get assigned these 100 shares. If the stock price does NOT drop and the option expires worthless, you get to keep the premium and, potentially, re-open another option contract to repeat the same.
  • In general, we want the choose a strategy such that the option contract expires worthless most of the time i.e. OTM. Why? This reduces our risk profile in that we essentially get paid for waiting (either for the stock to drop to our reasonable buy price OR stock price to reach a desirable sell price) without actually going through a trade of the underlying asset.

Note: In the above conclusions, I have avoided option margins altogether i.e. I am ensuring that all the collateral required for the option contract are coming from me and there is no reliance on my broker.

Risks

Trading, in general, is serious business and you can lose money if you are not sure what you are doing. Option trading is no different, the stakes are a lot higher if anything. Therefore, it is worth highlighting the risks associated with such trading:

  • Call option: In the event the option gets assigned and the stock shoots to the moon, you would be missing out on capital gains that you would have otherwise been entitled to if you had held onto the stock. So you have to absolutely certain about the underlying fundamentals of the business. If you don’t do so, you run the risk of selling a multi-bagger stock.
  • Put option: In the event the option gets assigned and the stock tanks to hit rock bottom, due to something fundamentally wrong with the underlying business. In such an event, you would be holding onto stocks that could potentially be worthless.

Beyond these, I have also come to realize that I would never consider selling covered calls on most of my dividend stocks. Why? Because if the option were to get assigned, the resulting stock sell would put an immediate halt to several years of dividend compounding and hurt my original yield-on-cost. The option premium + capital gains I would make as a part of the stock sell trade would not compensate for that. This is perhaps the biggest risk of option trading in my case, so I have to be incredibly careful in choosing which stocks to employ this strategy with.

Summary

There is a LOT more to research and understand in this subject, but hopefully this gives you an ideal launchpad into this area. As always, please do your own due diligence and see how this fits into your own investments. The idea here is to keep your…options…open 🙂

Cheers!

Discl: Long AAPL

Updates on Goals – Year 2021

It is shocking that we are already into the last month of the year 2021. I am so busy with life and work that I am unable to pay attention to everything else that is going on around me. Perhaps it is a sign to take things easy for a change and also not get too bogged down with responsibilities. As I write this, there is news about a new COVID-19 variant called Omicron that is supposedly originating from South Africa. At this point, I have pretty much resigned to the fact that COVID or some other variant of the virus will never go away and we will eventually run out of Greek alphabets trying to identify each variant.

But this post is, thankfully, not going to be discussing about COVID variants. Given that we are heading towards the end of the year and setting sights on 2022, I thought it is good time to look back at my year’s goals, review my progress and set new goals for the coming year.

Goal 1: Write atleast one post per week

Result: Not Achieved.

Maintaining a blog is a lot of work, much more work than one can imagine. Moreover, with a 9-5 job and also a family to take care of, I have very little personal time to do anything else. Why choose blogging then? For one simple reason: I really wanted to get back to writing and penning my thoughts down somewhere. Interestingly, writing helps me in my thought process. It forces me to introspect deeply about the subject. And since I am spending quite a lot of time thinking about retirement, financial independence through dividend growth investing, writing about these subjects would reinforce my own belief system on these subjects.

I kept a very lofty goal of one post per week this year, knowing fully well that I would most likely NOT be able to achieve this given my other responsibilities. But I wanted to try anyway. The pursuit would ensure that I keep writing often.

Although I missed posting every single week, I came pretty close than what I initially though. My average posting frequency was still pretty high for each month.

Goal 2: Div-Net associate membership

Result: Achieved.

My second goal this year was to engage meaningfully with the dividend investing community on the blogosphere and also the world wide web, in general. Through this blog and then, additionally, through Twitter, I have been able to reach out to several like-minded investors. Dividend growth investing can be very challenging. It is very common to sometimes lose focus and wonder if this is really is the right strategy. Talking to like-minded investors, listening and learning from their experiences helps immensely. There are so many alternative approaches within the umbrella of dividend growth investing that it helps to listen to counter viewpoints sometimes.

As far as the blogging community, I wanted to be a part of a network of bloggers who would blog on this subject. I learned about Div-Net by sheer accident, as I saw their badge appears on several blogs that I would regularly follow. I am happy that I was able to satisfy their entry criteria for associate membership.

Goal 3: $1000+ in annual dividend income

Result: Achieved.

Eventually, I decided to share my progress on my dividend portfolio mostly for my own self and I will continue doing so until it makes sense. If it happens to motivate someone in the process, I will consider that as a huge plus for myself.

I am happy to report that I am well past my stated goal of $1000+ for annual dividend income. Part of my goal when I started this blog was to report my monthly progress here. I thought about this pretty long and hard, because there is technically no reason for me to report my passive income on the internet. In fact, the dividend portfolio that I discuss on this blog is only a small portion of my net worth and I do not plan on disclosing the other portions of net worth.

Goals for Year 2022

I have penned down the following goals for the upcoming year:

  • Cover atleast 5 investing book reviews
  • Write alteast one blog post per week
  • Earn $3000+ in annual dividend income

The first goal will force me to read/re-read investing books that I have been on my “to read” list for a while. There is just no substitute to knowledge gained from reading books on investing, or any other subject for that matter. I have kept this to a reasonable number (5) thereby allowing me to read the book and deeply introspect on the subject matter.

The second goal is a repetition from last time. I want to be able to continue writing regularly on this blog and since I was not able to achieve this goal this year, I will try my best to hit this for the coming year. Fingers crossed.

The third goal also looks pretty aggressive. I have no idea what kind of expenses will hit my wallet in my coming year, so I do not know if I will be achieve a $3000+ figure on annual dividend income. Let us see how I do in that pursuit.

What goals do you have in mind for the upcoming year? Were you able to achieve your goals for the current year? Please let me know in the comments below.

Thanks for reading thus far…

Johnson and Johnson in the news

One of my “core” holdings, Johnson and Johnson (ticker: JNJ), has been in the news A LOT more recently. And while I typically do not reach to news especially when I consider is “noise” as far as my long-term outlook of the business, when the news item has a significant impact on my strategy, it is worth bringing-up here and laying down my thoughts on the subject.

So late last week (12th of Nov, 2021), news broke out that JNJ is planning on splitting its consumer products business from its pharma and medical devices businesses and create two independent publicly traded companies.

The press-release on JNJ’s investor page states that the “new Johnson and Johnson” i.e. the business division containing the pharma and medical devices portfolios, will be headed by Joaquin Duato, current Vice-Chairman of the Executive Committee, after Alex Gorsky, the current CEO, transitions over that role. Alex Gorsky would continue to serve as Executive Chairman. The new Consumer Products company (name TBD) will have a separate board of directors and executive leadership which will be announced in due course.

The split-up is planned to be completed by end of 2022. It is intended to be a tax-free separation.

The news release also states the following regarding shareholder dividend:

In addition, it is expected that the overall shareholder dividend will remain at least at the
same level following the completion of the transaction.

Obviously, there are not a whole lot of details in this press release and we will need to wait and see how this whole thing plays out.

Having said all that though, I am not very surprised by this decision. In my deep-analysis post for JNJ on this blog back in August this year, when I analyzed the major drivers for the revenue for the company in the last five years, I was surprised to see that the consumer health and medical device’s revenue contribution percentage was essentially flat or even slighting declining for the last 5 years.

This trend is consistent for a few more years before that as well. Most of the growth in the company has been from the pharma business segment. This changed my outlook slightly, because I was under the false impression that JNJ was like a “healthcare ETF” given the diversification within its business. At least this is the narrative that is touted all around the internet whenever you read about JNJ.

Such a split-up is not unique to JNJ. In the recent past, we have seen such split-ups in the healthcare industry with atleast two other big business houses: Pfizer (ticker: PFE) spun-off its UpJohn business segment and combined it with Mylan to form a business solely focused on biosimilars called “Viatris”. Similarly, Merck (ticker: MRK) completed its spin-off of Oragnon.

So how do I view this news then? I think it is a positive decision. In Peter Lynch’s “One Up On Wall Street“, he states that huge companies are slow movers in terms of their revenue growth. JNJ is a massive business with a market cap in excess of $430 billion. This split-up will help each individual company focus on its business and help drive revenue growth better.

Am I as excited about the consumer health business as I am about the “new JNJ”? Not so much. I never really owned JNJ for its consumer health business alone, but rather for the overall conglomerate and also the quality of its management. I think the “new JNJ” piece of the business has still a lot of value and growth left.

I have not yet made up my mind about the consumer health piece of the business. A lot will depend on how to business is structured, the quality of the management and the overall brand value. I will need to research that independently to make a decision on what I intend to do with that.

The point of this post is not a “I told you so..” moment. Rather, it is reinforce this notion that all businesses, as with life itself, are subject to change. And the value of doing your own research by reading the fine print of the businesses you own, is priceless.

Happy investing!

Disclosure: JNJ part of “core” category of my dividend portfolio. No positions in PFE or MRK at this time.

My biggest learnings so far

Each and every investor goes through his/her share of ups and downs through their investing journey. Not all investment decisions are home-runs, and anyone claiming this is not sharing the complete truth with you. Even Warren Buffett, arguably the greatest investor of them all, has admitted to making investing mistakes. And since investing is not a science but rather an art, we should add some “buffer” (or sometimes called margin of safety) in our investment decisions should they don’t quite go as planned.

But lets assume we do all that and one of our decisions indeed does turn out to be wrong. What then? Simply move on? Nope! Like with all things in life, mistakes are an opportunity to learn from and investing is no different. So here are some of my learnings from my investing journey so far.

Stop trying to track stocks on a daily basis

This first learning may come as a surprise to the reader. Let me elaborate on this. Aside from the fact that I rarely have time to look at the stock market on a daily basis, I find the process itself is an incredible waste of time. This is because this starts a vicious cycle of reading up about why a specific stock is up or down by a certain percentage. Most of the times, this reading is not very rewarding and only manages to feed into my biases (more on this in a separate learning below).

Ultimately, this whole process feeds will lead me to want to “do something” with my existing position. This might result in either a needless buy or worse, a needless sell.

Consuming news

This follows the first learning closely. It is incredibly easy to get swayed by news headlines on < insert your favorite financial news medium here>. Generally, the news broadcasters will tend to exaggerate these headlines for their vested interests. I try my best to avoid reading such articles and instead follow the news directly from the company’s press-releases, earnings reports etc. This helps me form my own opinion.

In the off-chance where I do read these headlines, I try to look past the headline itself and see how this news impacts my long-term view of holding this stock. Is this going to impact the company say 5, 10, 15 years from now? If the answer is no, then I move on other things. If the answer is yes, I will consider researching it some more.

It is important to understand though that “financial news” has the same debilitating effect as stock ticker tracking…it has a tendency of feeding your biases. In general, my sense is that the news is geared towards investors who are short-term focused, which is diametrically opposite to my long-term investing philosophy.

Convince yourself first

Sometimes investing can feel like a battle within yourself, where one half of your brain thinks a particular stock is worth buying or selling, and the other half is not convinced. One half thinks analytically, the other half relies on qualitative analysis. Neither half is more or less important than the other, they both have their place in the mental makeup of a successful investor.

But it is important that you don’t let either half be swayed by what someone else thinks of a particular stock and have them make that decision for you. For this reason, I try and make my own opinion from my own deep-analysis/research of my position. This helps me convince myself that the buck I am spending to purchase a stock is indeed well-spent.

Analysis Paralysis

One of the things that frustrated me as a beginner investor is getting standard advice from seasoned investors which goes along the lines: You have got to do your due diligence when investing. But it was not exactly clear what does “due diligence” really mean. At what point do I say: yes, I have researched everything there is to research about this company and I am ready to buy or not buy. I immediately realized that exhausting the research space for any given business is a futile exercise. The challenge being that you do not know what you do not know.

Instead, I have now begun to adopt an approach where I will initiate a position in a company if the initial research supports that decision and use the new information available (through press releases, financial statements, interviews with the company executives etc.) to further build my understanding of the business. Each new position will then be “promoted” to a new category depending on how confident I am regarding the business.

This may sound like a no-brainer now, but it was an important lesson in my education as an investor.

Waiting for a stock to reach your target price

This is a fairly controversial opinion. So I want to give some backdrop here before I state my position.

In my opinion, dividend growth investing and value investing are tied to each other at the hip. Every dividend growth investor is also a value investor in some sense. Why? Dividend growth investors are focused on improving their portfolio’s overall yield-on-cost. And to ensure that, they will need to ensure that what they are buying is reasonably priced. Another way to state this: Yes, you are building a passive income stream for yourself through dividend growth investing, but what exactly are you paying for that passive income stream? Is that a reasonable cost?

This is why determining the intrinsic value/fair value of a business is crucial. And there are several valuation techniques available for this estimation.

So say you did all that, you determined a fair value of a business, added in a margin-of-safety and then wait for the stock price to reach your desired buy price. But what if this wait is decades long. Is this the right approach then?

Or are you suffering from anchoring bias, where your brain is transfixed on your target buy price?

I have struggled with this myself and I have determined that for a business that I am confident is extremely high-quality, sometimes it is okay to be paying to premium to have it in your portfolio. This followed by consistent dollar-cost averaging into a position is probably a better approach then waiting for the stock to reach your target price.

And when the stock price does indeed reach your updated target buy price, you double-down, buy more and add aggressively to your position.

In my mind, this approach makes more sense and seems to be working better for me. But time will tell if this was a mistake.

Summary

Learning is a continual process and I hope that remains true for me even as an investor. I hope to follow-up on these learnings in a future post.

Let me know what you think. Do you agree? do you disagree? do you have some other thoughts? I would really love to hear from you.

Thoughts on investing philosophies

I wanted to take a step back from the dividend portfolio updates and talk about a subject that has been on my mind lately. Investing is such a diverse topic with various facets that sometimes it is easy to muddle things up and ultimately lose focus. While I was beginning my investing journey, I found it overwhelming and confusing to listen to so many “experts”. It was difficult to understand and chalk out what was the right path forward that would meet my goals. I would like to share my thoughts on this subject to aid some new investors who can hopefully learn from my experience. I’ll try divide these into individual sections and cover them one at a time.

Investing strategy

This is such a hotly debated topic in the investment community. There are various strategies available to the individual investor: growth investing, value investing, dividend investing, index fund investing etc. And while there is no right or wrong approach with each of these, it is amazing how passionate some folks get when discussing this subject. Eventually, this discussion starts tending towards “the approach that I have chosen is the best and all other approaches suck!”. Ultimately, this leads into a mindless debate with no desirable outcome for anyone involved.

I can illustrate this with several examples with regards to dividend growth investing. For instance, the inter-web is full of discussions regarding the dividend irrelevance theory. I have also heard several other arguments against this strategy. Some of these revolve around subjects such as: taxes incurred on the dividend income OR how there is very limited stock price appreciation on some stocks that get touted as great dividend growth stocks (think PepsiCo (ticker: PEP) or Johnson & Johnson (ticker: JNJ). Often times, this discussion starts to get into ridiculous territory with comments like “dividend growth investing is so boring and not sexy at all”, whatever that is supposed to mean.

It is important to understand that there are multiple approaches to investing and your approach is unique to YOU. And since it works for you, that is all that matters in the end.

It is also important to highlight that your approach could be a unique mix of different styles of investing. Just because you are invested in dividend stocks does not mean you cannot invest in growth stocks. You can do both! In fact, when I own companies like Microsoft (ticker: MSFT) and Apple (ticker: AAPL), I can justify that I am owning both dividend AND growth stocks. It is called dividend growth investing, after all, for the same reason.

Similarly, just because you are invested in individual stocks does not mean you cannot invest in ETFs. You can do both here as well! You are just using your unique strategy to achieve your financial goals and you must avoid getting into the business of championing the strategy itself. The strategy is just the means to achieve the goal, it is NOT the goal itself.

“Sin” stocks

This is a subject that has come up so often in my education as an investor. In general, sin stocks refer to companies whose central business can be considered to immoral or unethical. The tobacco stocks such as British American Tobacco (ticker: BTI), Altria (ticker: MO) or Phillip Morris (ticker: PM) often get cited in this bucket. Other companies that are lumped together in the same category are the “Big Oil” companies such as Exxon Mobil (ticker: XOM), Chevron (ticker: CVX) etc. The rationale being that these companies are causing harm to our natural environment and therefore “bad“. The next category of companies are those that are involved in producing weapons, which then subsequently are used in wars by defense forces. Some examples are Lockheed Martin (ticker: LMT), Raytheon (ticker: RTX) etc.

In my opinion, the moment you start mixing ethics with your investments, you are going down a slippery slope. Every single company, irrespective of how great it is or has been in its past history, would have been involved in some questionable business practices throughout its history. In one of my earlier posts where I discussed JNJ in fair detail, I mentioned how even a great company like JNJ has been involved in some litigations. One could argue that snack food and beverage companies such as Coco-Cola (ticker: KO) and PEP are “evil” because some of their products are bad for their consumer’s health. There are several other examples in other industries: Microsoft, Apple, Facebook, Google, Amazon etc. have all been in the dock at one point or another for anti-trust hearings and alleged business practices that attempted to thwart any competition. At the time of writing this, Facebook is in the news for wrong reasons where a whistleblower has indicated how Facebook and Instagram have deliberately ignored research data that shows how their platforms have a negative impact on the mental psyche of their users. To be honest, this news is not surprising to me, and one of the reasons why I dropped off from Facebook a few years ago. Looking back, it was a fantastic decision!

Every company at some point in its lifetime has had some such negative news. Even with a boring and predictable business like that of Waste Management (ticker: WM), we have seen instances of fraud.

So, where does one draw a line? Is this such a black-and-white classification after all or are there several shades of gray here? It is hard compass to judge any company on.

For this reason, my metrics when choosing a business are pretty straightforward: does it make long-term sense for me to invest in this business AND is it a business that I can understand and reason about logically. If the answer to both those questions is yes, I then proceed forward with further analysis. Most of my analysis is tended towards looking for reasons to NOT want the own the stock. This way I play devil’s advocate against myself with a hope that doing so will keep my biases at bay.

I also support my analysis in a quantitative fashion with valuation techniques such as discounted cash-flow and dividend discount model, padded with a margin of safety. The margin of safety here is critical, since there is risk associated with every business, the risk being that I could potentially lose 100% of my invested capital.

Once I am happy with my analysis, I initiate a position and then consistently dollar-cost average into that position. This further attempts to keep emotions out of the decision of buying.

Investing for other motives

During the whole GameStop fiasco earlier in the year, I was carefully waiting and watching on the sidelines as that whole episode was playing out. While reading about the news on various platforms, I was coming across comments where some people were investing “to teach the big guys a lesson” and “standing up for the small time investor”. While I can understand the enthusiasm and the thrill, using your (or someone else’s) hard earned money to “make a statement” OR “be a part of a public movement” is a recipe for disaster. In general, if there such a mass hysteria going around, it is always better to take a step back and really contemplate if the investment decision you are about to execute really makes sense to you and is in your long-term interests.

We have had so many examples of such events from the past. Tulip mania comes to mind readily. Here is another excerpt from The Intelligent Investor, arguably the best book on investing ever written.

And while we are on the subject, beware of those who are instigating you or asking you to invest in a stock because they think it is the right thing to do. Such people are two-faced liars and are only looking out for their interests.

Summary

So there you go. I think some of that post might sound like a incoherent rant to some folks and some others might take this as useful advice. In any case, my central goal is to motivate you to do your own research and think about what your strategy is before investing a dime in the market. If I have forced you to think about this subject, I would count that as objective achieved.

Thank you for reading thus far.

PS: You can find me on Twitter @LifeWDividends

Disclosure: Long JNJ, MSFT, AAPL, WM, PEP, XOM, LMT. No positions in Facebook, Google, Amazon or Coca-Cola, MO, PM, BTI, CVX, RTX

John (“Jack”) C. Bogle – 10 Investing Principles

One name that keeps consistently coming up in my education as an investor is John C. Bogle, the person who gave us Vanguard and also the concept of index funds. I have been watching/listening to some of his interviews before his death in Jan. 2019. Even at an age of 87, the man was so sharp! And I must say, every single time I listen to him speak, I learn something new.

John’s statements are easy to co-relate with the historical stock market data i.e. passive index investing generally gives the investor better returns at lower costs compared to actively managed funds. It is for this reason that a large portion of my net worth is tied up in low-cost index funds from Vanguard.

Regardless of what your investing strategy is like, it would be wise to listen to experienced heads such as John and adopt those learnings into your overall investing mindset.

In this post, I wanted to highlight 10 such investing principles that I have heard from his various interviews/speeches/books.

1. Reversion to the mean

Don’t choose funds based on past winners. One way or the other, all mutual funds do badly in one period and do better in another period

This is true of all investments in general. Past performance alone cannot guarantee future results. With every investment, it would be wise to look towards the future and question if the investment makes a good long-term choice for your portfolio.

2. Time is your friend.

Think of the value of compounding. Get yourself a little compound interest table and see that at 7%, money doubles every 10 years and it doubles again and again and again. And by the time you are at your retirement age, it might 35 to 40 times your original investment…maybe more than that.

I demonstrated this very concept in my previous post where I discussed Yield-on-Cost. This is such a powerful concept that can achieved through a simple buy-and-hold strategy with dividend growth investing.

3. Buy Right and Hold Tight

Pick a good fund and hold it through thick and thin. Don’t get despondent when it does badly, because it comes and goes. So don’t let yourself get distracted by changes in the fund performance or changes in the market.”

Again, some sound advice about any investment vehicle. During a market correction, it would be wise to disregard all the market headlines and look instead at the fundamentals of the businesses you have invested in. If nothing materially has changed, stay put.

4. Have realistic expectations

I think common stocks should return at a nominal rate, nominal meaning before inflation…at a nominal rate of 7%. The dividend yield is very important in all this. Reasonable rate of return would be 7%, don’t look for 11, don’t look for 15, don’t look for nothing, don’t keep waiting for the next bear market….those are all guesses! Some of these guesses will come good, some not so good.

Several pearls of wisdom in that statement alone. In general, when attempting to draw estimates about projected growth in your portfolio or also things like valuing a business, it is better to remain conservative. Other useful takeaway is to remain invested in the market and not wait on the sidelines.

5. Forget the needle, buy the haystack

You don’t need to take the risk of owning individual stocks, take the market risk, which is high as it is“.

I think I largely agree that for a common individual who is least interested in the stock market news and the world of finance, this would be great advice. However, I prefer a slightly hybrid approach where I have a large portion of my net worth invested in low-cost index funds and a smaller portion invested in dividend growth stocks.

6. Minimize the Croupier’s take

Cost is an important factor

Ensure that if you are investing in a index fund, it is low-cost. The expense ratio can add up over time and take away a significant portion of your total return.

7. There is no escaping risk

Think about this for a second..I don’t like the risk of the stock market. I am putting my money in a savings account or certificate of deposit. There is no risk there. Wait a minute! The return there is probably going to be about 1.5% and we are going to have 2.5% inflation. The real return is -1%! So is there any risk in putting your money in a savings account? You better believe it!

Stay invested and stay the course. Obviously, set aside some cash for emergency expenses. But keep the remainder invested. Cash sitting in a bank account will slowly get devalued over time.

8. Don’t fight the last war

Your job is to get the biggest gross return…inflation is going to take whatever it takes out of that. If it is big return, it will take a little of it. But if the gross return is small, it will eliminate it!

Jack was referring to safeguarding against inflation through special funds like “inflation beaters” (his words, TIPS?). In general, my takeaway from this was staying focused on one primary strategy and to not make sweeping decisions based on problems that existed several years back or that might possibly exist several years into the future.

9. The Hedgehog beats the fox

The fox knows many things. But the hedgehog knows one great thing. In our business, foxes are those harvard business graduates with their fancy computers…armies of them..who know many things. I know one great thing, which is if you own the market in a low-cost index fund, you are guaranteed to earn your fair-share of what the market is kind enough to give us, and lets be clear on this, whatever returns a bad market is mean-spirited enough to take from us. So it is the hedgehog who wins ultimately“.

Simple boring strategies ultimately have the highest probability of success, as compared to complicated strategies that involve timing the market.

9. Stay the course

Let me start with this premise…Many investors lose because of their own behavior and not because of how stocks and bonds do. They are trailers…they buy something that has done well and expect it to perform the same in the future, and it doesn’t. A whole lot of bad behavioral patterns…the find a hot stock manager, they jump on the bandwagon and that does not work….that will not work. So figure out a sound program, set the right course and don’t let all these superficial emotional momentary things get in your way! Another way of putting that is, don’t do something, just stand there!

Again, so many pearls of wisdom from the legend. I have previously written about cognitive biases and how that impacts investment decisions. A good investor must be cognizant of these and try their best to avoid such biases creeping in. Another advice is to avoid frequent tinkering with the portfolio based on market news. In fact, I find it easier at times to “zone out” and stay away from the news and headlines and instead focus on big picture and long-term fundamentals.

So there you go! Words from the legendary John C. Bogle. Dear Sir, I thank you humbly for all your contributions to this world. I am a better investor thanks to you.

The Importance of Yield on Cost

Traditionally, the annual dividend yield for any given holding is defined as the annual dividends payed out divided by the current share price for the holding. As an example, at the time of writing this article, Visa (ticker: V) is trading a Price per share (PPS) of $238.47. Currently, Visa pays an annual dividend of $1.28. This gives us an annual dividend yield of 0.53%.

If one were simply looking at that current dividend yield as a screening criteria, 0.53% for Visa does not make it look like an attractive investment from a dividend cash flow perspective. However, throw in the notion of dividend growth from the company and also holding the stock for a really long-term, that initial dividend yield will compound into snowball and start yielding at a much higher rate in a few years. This is through the magic of yield on cost.

Unlike the annual dividend yield, Yield on Cost (YoC) is defined as the annual dividends being payed out currently divided by the original purchase price for the holding.

Let us explain this through a simple example, again sticking with our example for the Visa stock.

For our simple modeling, we will use the current 5-year Compound Annual Growth Rate (CAGR) of 18%. Compound Annual Growth Rate for dividends is defined as follows:

CAGR = [FV / IV]^1/n – 1

where, FV: Final value of the dividend after n years

IV: Current value of the dividend

Assume that you were going to purchase a Visa share today at the current stock price of $238.47. Also, assume that Visa can maintain this dividend growth rate for the next several years. With these assumptions, we get the following results:

YearDividend AmountYield on Cost
0$1.280.53%
5$2.931.22%
10$6.702.8%
15$15.336.42%
20$35.0614.70%
25$80.2233.63%
30$183.5177.0%

So from the table above, we see that the Yield on cost for year 0 starts out at the same rate as the typical annual dividend yield. However, we see that just by holding the stock for several years, and due to the power of compounding, the yield on cost with respect to the initial purchase price after a period of 30 years is a whopping 77%!

Therefore, for the compounding through yield on cost to work, there are the following important considerations:

  • Need to invest early enough to allow for the compounding to do its thing.
  • Need to purchase great companies with solid growth potential at a reasonable valuation (thereby ensuring a great starting dividend yield).

Now, I know the sceptic in you is asking some very pertinent questions about the model above:

Is it fair to assume that Visa will be able to grow at the same dividend CAGR for the next 30 years?

Good question. And most probably not. But it is reasonable to assume that Visa will be growing their dividends at a pretty aggressive rate for the near term and then slow down after that. Playing around with the dividend CAGR rates a little, we arrive at the following results:

5-year CAGR/ Years051015202530
12%0.530.941.662.935.179.1216.08
15%0.531.072.174.368.7817.6635.53
18%0.531.222.86.4214.733.6377
All values for YoC in percentages

Even if we assume a slowing down in the 5 year CAGR rate for the entirety of the 30 years, at a CAGR of 12%, the YoC is still is a respectable 16.08%.

But you have not assumed any re-invested dividends?

That is correct. I am assuming that dividends are not reinvested for the purpose of simplicity.

So does this mean that the current yield is irrelevant and one must always look at the dividend growth rate?

This is a classic question amongst all investors in the dividend growth community. And like with everything in investing, there is no black and white answer here as well.

In my case, I tend to categorize my portfolio amongst a mix of low current yielders with high growth rate, high current yielders with slower growth rate and also some that are in the middle of the road. Why so? Several reasons:

  • The categorization gives diversification to my portfolio: Some companies simply cannot raise their dividends at a faster rate because of the nature of the sector they are in e.g. public utilities, companies in the telecommunication sector.
  • Some companies are lot more mature than others: I hold some classic blue chip companies that have been around for several decades. They have an enormous market cap and will probably not be able to grow aggressively like some of their younger counterparts.
  • Momentum: Yes, I will admit it. Seeing some high yielding stocks now, giving me back good cash flows at present will motivate me to stick to this strategy. This is a strategy that requires enormous amount of patience. Seeing that cash flow working its magic is a re-assurance that this strategy is indeed working and will serve as a momentum boost. While this is more psychological than anything else, there is nothing particularly wrong about the approach.

Like with all metrics, I would recommend using YoC in conjunction with their several other financial metrics to analyze the health of your portfolio, rather than in isolation.

Disclaimer: Long V

Cognitive Biases during Investing

Things have really been getting a lot busy with work and life lately. It is summer time here in the US, and from what I can tell, the general public is out and about, trying to spend a lot of time outdoors. I can see the pandemic restrictions being lifted as well and it seems like things are slowly returning back to some semblance of normalcy. The markets are rallying along as well, and even all this talk of inflation has not really slowed it down. Does this mean that Mr. Market is treating this rise of inflation as a transitory event? Time will tell.

Even with all this news, I am continuing to stick to my strategy. While I tend to my responsibilities of my day job and my family’s needs, my capital deployed in high-quality businesses earns passive income for me in the form of dividends.

In my spare time, I have been binge-reading articles/watching videos on valuation, with an overall goal of adding more tools to my repertoire to analyze businesses effectively. One such person who has been widely quoted on the subject of valuation is Prof. Aswath Damodaran from the NYU Stern School of Business. If you have not checked his website, I humbly urge you to do so, as I think it is a treasure-chest of useful information/tools on the subject of valuation.

One of the topics that I happened to read about is how biases can impact valuations and this subject perked my interest. Here is what Prof. Aswath writes on this subject:

When you start on the valuation of a company, you almost never start with a blank slate. Instead, your valuation is shaped by your prior views of the company in question. The more you know about a company, the more likely it is that you will be biased, when valuing the company…In principle, you should do your valuation first before you decide how much to pay for an asset. In practice, people often decide what to pay and do the valuation afterwards.

Cognitive biases, in general, impact our ability to think and reason logically. Investing is no different. It is important to understand them and ensure that you are avoid them when evaluating businesses. Here are some well known biases that can impact your investment decisions.

Anchoring Bias

We humans tend to rely a lot on the very first piece of information that we receive and use that as an anchor or an initial reference point. As we receive new information, it is processed with reference to this anchor.

Anchoring is used very effectively by folks in the sales and marketing domain. One example that readily comes to mind: if you are ever at a car dealership shopping for a new car, notice how the car dealer will first show you the expensive models before showing you a “cheaper” model, thereby prompting you to buy the latter.

Here is another classic example, this time it is Steve Jobs using anchoring during an iPad promo event.

Anchoring, by itself, may not be such a bad thing in investing, if you are anchoring your brain to the intrinsic value of the investment. However, if your brain fixates on the wrong data point, such as say stock price alone, it can have a damaging effect on your decision making.

Confirmation Bias

Simply put, confirmation bias is a tendency to only search for, favor or interpret proofs that align with our existing point of view. In fact, taken to its extreme, this can result in misinterpreting contradictory evidences to support the current view.

This can be particularly harmful when objectively analyzing a business. If you are approaching the analysis with a “loaded mind” where you already think that “This is a great business“, you will tend to interpret data put in front of you through this prism and simply dismiss other non-conforming data as outliers.

Outcome Bias

This is a tendency to base the effectiveness of a decision through its eventual outcome, and neglecting all the other factors that may have contributed to the outcome. I view this bias through two hypothetical examples:

I bought a stock, and the stock price went higher the next day. Therefore, my decision to buy was correct.

OR

I sold a stock, and the stock price dropped the next day. Therefore, I am right about selling this stock.

Conventional wisdom states that the stock price is probably the worst place to look at when it comes to validation for your decision to buy/sell a stock.

Bandwagon Effect or Herd Mentality

This is a tendency of adopting a specific style or belief simply because others are doing it. In investing, this might be summarized as:

Everyone is buying this stock, therefore it must be a good business.

There is also the common case of FOMO aka Fear Of Missing Out, because you are always wondering about what the other investors know about this business that you don’t.

There are several examples from history to show how this generally does not end well for the investor. One such funny example is quoted by Benjamin Graham, the Godfather of Value Investing, in his famous book titled The Intelligent Investor:

And back in the spring of 1720, Sir Isaac Newton owned shares in the South Sea Company, the hottest stock in England. Sensing that the market was getting out of hand, the great physicist muttered that he “could calculate the motions of the heavenly bodies, but not the madness of the people.” Newton dumped his South Sea shares, pocketing a 100% profit totaling £7,000. But just months later, swept up in the wild enthusiasm of the market, Newton jumped back in at a much higher price—and lost £20,000 (or more than $3 million in today’s money). For the rest of his life, he forbade anyone to speak the words “South Sea” in his presence.

Availability Heuristic Bias

This is a tendency to place undue importance on events and examples that come readily to mind. This is easily seen in a lot of commentary and analysis on investing. Investors tend to remember the dot-com boom or the Great Financial Crisis in vivid detail and sometimes use that a basis for future investments.

So what does all this mean?

Through this discussion, we can derive the following conclusions:

  1. Your greatest enemy and your greatest friend in all your decisions, investing or otherwise, is your very own sub-conscious.
  2. If you already own a particular stock and think the underlying business fundamentals are sound, one technique that I have found useful while analyzing such a holding is playing the Devil’s advocate i.e. now look for reasons why you would want to sell this stock and be as objective as you possibly can.
  3. Valuation is not an exact science, quite far from it actually. In fact, as a result of these biases and assumptions, there is a good chance that your estimations are completely wrong. It is for this reason that diversification in your portfolio helps to safe-guard against such bets going wrong.
  4. When in doubt, use the philosophy based on Occam’s Razor i.e. the simplest explanation/model is usually the best way to attack an estimation problem. The more complicated your model gets (including more inputs and assumptions), the greater the risk of your biases sneaking in.
  5. Always invest with a Margin of Safety, because at the end of the day, all valuations are estimates and they could be wrong.

That’s it, folks! I hope you found this article useful to read. Please drop a comment below to share your thoughts on this subject.

Until next time…