This post was originally published on this site
Investing is a forward-looking endeavor. Investors need to build a portfolio for the economy that lies ahead, not the one in the rearview mirror.
Unfortunately, the view of the road before us is murky at best. History is not very helpful either, as the global quantitative-easing experiment has never been attempted at its current magnitude. How can investors prepare for the consequences of such engineered, inorganic growth?
To paraphrase Warren Buffett, “To finish first, first you need to finish.”
The stock market today requires that you build an “I don’t know” portfolio — a high-quality group that is equipped for any conditions. To get a picture of this all-road vehicle, in practical terms, let me explain my firm’s three-dimensional analytical view of stocks: quality, valuation, and growth.
The valuation (the worth of the business) and growth (earnings growth and dividends) aspects have a dual purpose: They serve as a source of returns and as protection against losses. If you pay 50 cents for a company that is worth $1 — a 50% margin of safety — and the stock goes to $1, that is the valuation dimension working as a source of returns. Plus, that 50-cent investment can tolerate a lot of bad news before you lose money — that is margin of safety working to protect you against losses.
The growth dimension protects you against the clock. A company that is growing earnings and paying dividends is compensating you for your time. Dividends tangibly enrich your P&L on a quarterly basis. Earnings growth increases the value of the company over time — if earnings double, that aforementioned 50 cents turns not just into $1 but $2.
Now, how about the quality dimension? A traditional definition of a quality company checks off these boxes: a significant competitive advantage; high return on capital (which usually accompanies a competitive advantage); good management (skilled at both running the business and allocating capital), and a solid balance sheet.
A simple test for what constitutes a quality company: one you would be comfortable owning for five or 10 years.
A simple test for what constitutes a quality company: one you would be comfortable owning for five or 10 years, or if an unexpected event forced the stock market to close indefinitely.
Of course, in an environment where the true cost of money is unknown (due to central banks’ machinations) and global growth has become a Frankenstein-like creation (thank your local central banker again), the valuation and growth dimensions have lost their tangibility for lower-quality companies. You thought you were buying a $1 company for 50 cents, but in the absence of quality, valuation can degrade much faster than your margin of safety and $1 can turn into 20 cents in a New York minute.
Quality is the foundation of the all-terrain company — and portfolio. They must be able to survive anything thrown at them by the global economy.
So, how does one invest in this overvalued market? Our strategy is spelled out in this fairly lengthy article.
Vitaliy Katsenelson is chief investment officer at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing” (Wiley) and “The Little Book of Sideways Markets” (Wiley). Read more on Katsenelson’s Contrarian Edge blog.