- Investing now is extremely risky, but there’s a way to make money no matter what happens.
- The strategy is really simple. The best things related to investing are always simple.
- There are two key factors that give a 100% guarantee for long term capital creation.
The main investing goal for everyone should be to increase one’s wealth over the long term. However, many are confused by the constant fluctuation in stock prices and the fact that, in hindsight, it looks like there are so many opportunities to make a quick buck on the stock market.
Investing isn’t as easy as it may look when looking back on what happened in the past. The problem is that nobody knows what will happen in the future. However, there is a strategy that will allow you to increase your wealth no matter what happens.
For starters, you want to invest only in stocks that have a healthy business model, a good brand, pay a dividend, and are expected to continue to grow in the future. I think Berkshire Hathaway (NYSE: BRK.A, BRK.B) fits that description perfectly, so we can use it as an example. However, BRK’s stock price is almost at $300,000, which is almost 4 times more than what it was in December 2008.
Despite the record high stock price, BRK’s price to earnings ratio is 26. That’s a bit higher than usual as the hurricanes in 2017 did increase insurance related expenses and lowered BRK’s net income. Nevertheless, investors can expect a 4% earnings yield while Munger and Buffett aim for a 10% earnings growth rate over the long term.
If we compare 2008’s earnings per share of $8,548 with 2016’s earnings per share (not impacted by hurricanes) of $14,645, we can see that they didn’t manage to grow earnings at 10%, but they did still deliver a good 7% per year, and that is something we can expect for the future.
If BRK’s earnings grow at 7% over the next 10 years, 2028 earnings will be $23,903.
The earnings and their growth are the most important part of value creation when investing. So before making any investments, you have to be happy with the earnings yield the investment provides. Anything else apart from the earnings yield is just speculation.
Now, let’s say you invest in BRK now and the stock drops 50%. That happened in 2008, and in 2012, the stock price was at $150,000, so no one can say that such a scenario is unlikely, especially if required market valuations change. If the required valuation for BRK drops from 26 to 13, you would still be above water in 2028 as earnings of $23,903 and a valuation of 13 would result in a stock price of $310,000.
That wouldn’t be a great return, but still, if you look at earnings yields, earnings growth, and allow for a long term investment horizon, there is really little possibility for not making any money. However, there’s a way to increase your returns and limit your risks even if the stock price drops 50%.
Further, the market’s required earnings yield is always volatile. Just look at the figure below that comprises almost 150 years of stock market data and looks at the Cyclically Adjusted Price to Earnings ratio (CAPE) which takes 10-year average earnings when calculating valuations.
Just in the last 30 years, the market’s CAPE ratio has gone from below 10, to above 40, down to 15, and now it is over 32. Perhaps the market’s valuation in 2028 will be 13, but in 2030 it could again be 26 and then your BRK investment will be close to $600,000 rather than $300,000. A strategy that takes advantage of such valuation fluctuations is investing in stages.
Investing In Stages
Apart from the focus on the earnings yield, investing in stages according to a set valuation metric will also allow you to always win. For example, consider that a 4% earnings yield is risky from an historical perspective, a 6% earnings yield is average, while an 8% earnings yield carries little risk for your long-term investing goals. What you can do is invest 33% of your portfolio now, add 33% when the yield is at 6%, and be fully invested when the yield is at 8% and then rebalance accordingly. In the long term, the market’s required earnings yields will be volatile and you can increase your returns while lowering your risks.
Now, you might invest just 33% now and then see BRK’s stock go to $400,000 and cry over the missed opportunity, but investing isn’t about missing a train, investing is about not going under a train. Therefore, if you limit your risks, the probability that you will increase your wealth in the long term increases significantly no matter what happens in the stock market.
What I’ve described above is simple and that is exactly how investing should be. The simplicity will allow you to reach your long term financial goals with certainty.
As for the investments, it doesn’t have to be BRK, it can also be a well-diversified global basket of similar companies with healthy business models, but that’s a topic for another article. So keep reading Investiv Daily.