Start with Index Funds
Before getting into picking stocks, it’s worth noting that a good portfolio is largely allocated to low expense index funds. Over the long run, Index funds provide the most consistent returns, a solid dividend to reinvest, and can provide a great foundation to build your portfolio on. If you’re not planning to use the money for 5-10 years, you should be in about 75-80% in an S&P500 Index fund and make sure the dividends get reinvested automatically. This is also an efficient tax strategy for a taxable account. Since you will never sell these funds, they will become long term capital gains, which are taxed at a much lower rate. I recommend using ETF’s such as (VOO; IVV; SPY; RSP). I personally invest in VOO and RSP, the two things to consider when investing in an index fund are: how well does it track to the index it follows, and how expensive is it (expense ratio).
How I Pick Individual Stocks
Lately, I have been adjusting my investing strategy by looking at the long-term potential of the company vs just the valuation fundamentals. You can write a narrative of what you believe the future will look like in say 20 years:
Money In the Future:
- Physical cash will be obsolete – invest in companies like Visa, Square, AMEX, etc.
- Cryptocurrencies will weed out the small ones, one or two main leaders will start to go mainstream. Bitcoin is still the leading contender, but has large hurdles to become an actual useful currency:
- There could be a major shift towards cryptocurrencies if the US monetary policy (in 2020) leads to long term inflation or instability.
- Cryptocurrencies will become a larger part of our economy, however, the only value now is based on speculation. Cryptocurrencies are, by their nature deflationary currencies (the supply is limited, so the value goes up the more it is in demand/used). The deflationary currencies aren’t very useful for purchasing things since people think “why would I buy that iPhone today with this Bitcoin? The value of the bitcoin could increase tomorrow and the iPhone would be cheaper!” People aren’t using Bitcoin to actually purchase things in high volumes yet.
- Governments cannot control cryptocurrencies, and will likely do everything they can to slow/stop them (the government likely won’t succeed)
- Normal banks will have to embrace cryptocurrencies. Find the ones that are adapting or the newcomers without corporate baggage slowing them down (SQ)
- Despite this, I am still not comfortable putting a lot of money into cryptocurrencies right now. I will likely reconsider often, but I don’t think it’s a good primary financial allocation at this point. I don’t understand it well enough to put my money on it…
Technology
- Artificial intelligence will grow exponentially. This growth will have an impact on how we learn, manufacture, manage, accounting, etc. There are some big players out there making ‘home-grown’ solutions, but companies like C3.ai (AI) could be huge in the future and disrupt companies like Oracle.
- Social media will continue to expand its control and AI will replace low-level analytical jobs
- The majority of retail be from online sales, malls and big-box stores need to adapt or die
- Ridesharing will expand greatly and become automated (Uber/Lyft). Traditional car ownership may change to looking more like a subscription service.
- The gig economy will increase and become more global. This may have a negative impact on US wages since it’s easy to outsource on Fiverr
- The sharing economy is positioned to be bigger than the gig economy because there are so many under-utilized assets being tapped into for the first time. Airbnb will continue to dominate, and the overall scalability can be huge
- Trucking/logistics industry (Workhorse)
- The industry will be automated – long haul will go first, local delivery will take much longer to automate
- Automation will continue to erode US manufacturing jobs… the demand for engineers will be the bottleneck in the near future. AI/Machine learning will need to get much better to remove this bottleneck, but I would bet on AI over traditional manufacturing
Energy/Sustainability – Energy has always been a huge sector of the economy. Just look at the fossil fuel industry over the last 100 years. Their time is over though. We are starting to glimpse at a world without fossil fuel dependence. It’s not political, it’s the technological reality.
- Ask yourself the following: in 100 years, do you think we will still be using gasoline engines in our cars? Of course not, and if you think we are, go ahead and look at Exxon Mobil stock, they used to be the most profitable and largest market cap company in the world. Invest in them if you think the stock market is wrong… or you can invest in a more sustainable future: so what is that going to take?
- Renewable energy (solar) will continue to trend cheaper, accelerating fossil fuel obsolescence (TAN)
- Energy storage solutions will become more critical due to inconsistencies in renewable output. Who are the main players that are best positioned to build market share? (TSLA is making huge strides in both production and storage)
- Lithium is the new oil. Lithium production into batteries will be heavily demanded. Instead of investing in the commodity, who are the best companies at converting it to a useful product?
- With more electrified vehicles, it will mean a few things:
- Our electrical grid needs improvements to support charging EV’s
- Charging stations will increase in importance, long term replace gas stations
- Solar energy storage is critical because the grid demand will be at night when people are charging their cars and the sun isn’t shining
- Clean water will be critical in the future. It’s already scarce now.
- China is investing heavily in renewables, they understand the opportunity and are trying to win the market.
How to Manage Risk in Stocks
When Stocks fall, they actually get less risky. It’s when valuations are too high that you need to be really worried. Market crashes are a great opportunity to buy great companies at a huge discount. You just need to keep a long-term viewpoint “did the stock market crash that just happened change the fundamentals of the business I want to buy?” if the answer is no, you should buy it. I missed the first Tesla spike of 2020 after groveling for years that I thought it was a good company that was overvalued. When It went close to $1k I thought I had really missed my opportunity. When COVID -19 hit, it cratered the stock down to the mid-300’s where I picked it up a few dollars off the low point. As of writing this, the stock is up around $2,400 pre-split adjusted.
Overvalued Stocks vs. Growth Potential
I bought Tesla even though I thought it was overvalued at $378 (pre-split) – why? After missing out on the Amazon and Netflix growth over the last 10 years. I remember saying “I’m waiting for Amazon and Netflix to drop before getting into them, they are overvalued…”. I have learned is that great high-growth companies trade at higher earnings multiples, and a really good company should be looked at with a 10-year time horizon. I bought Tesla because I said “It’s overvalued at $100M market cap, but I think in 10 years it will be over $2T market cap” I’m pretty sure anyone would be excited about a 2,000% increase in value over 10 years. As of writing this, my shares are up 500% over the last 7 months. I still think it’s overvalued, but I’m not selling since I still think it will be worth at least $1.5T+ in the next 10 years.
The key is patience and understanding the growth story for that company. Especially if you think a company is overvalued, there is a good chance it will have a 30-50% drop at some point of you owning it. The naysayers will say “I told you so” while you add to your position because the business case is still there.
Fundamentals and Company Financials
Before buying the companies in the industries I just highlighted, it is important to have an understanding of how the company makes money and the financial health of the company. Traditional companies are valued using what’s called a discounted cash flow. An analyst makes an assumption of future cash flows, then discounts them to present value. There are a ton of assumptions that go into this, but it ends up with a fair market price. Then you would compare that price with the actual market price to determine if it is overvalued or undervalued in the market. In recent years, we’ve seen a divergence from this method as more tech companies make up a greater weight of the S&P 500. This still applies to more traditional and established companies: banks, manufacturing, retail, etc.
Speculative/Tech companies require a different kind of financial analysis. Here are the things I focus on:
- Cash on hand/Cash flow – does the company have enough cash as they grow into profitability? If not, do they have the ability to borrow more? Or will they issue more shares, which would dilute all current shareholders?
- How does the company make money? It seems very simple, but you should understand how a company actually makes its revenue. For example, Facebook makes revenue mostly from Ads. So user growth is important, but it’s more important that they are able to monetize that user growth. User growth + online retail growth rates are the indicators for the future revenue growth of Facebook revenue.
- Disruptive Technology – what are the technologies that are changing industries? Amazon changed retail, Netflix killed blockbuster, Uber is disrupting taxis, Airbnb is disrupting hotels, Bitcoin is disrupting banks, Robinhood is disrupting brokerage firms, Tesla is disrupting the auto industry. Look for the companies that are changing the rules of the game. The ‘old guard’ doesn’t know how to react.
Conclusion
Paul Graham said about how to get startup business ideas: “Live in the Future, then build what’s missing”. This follows the same advice but applied to an investing strategy.
Please leave any specific questions or thoughts in the comment section. I’ll be adding to this post as I continue to evolve. Let me know what you think!
