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Financial Freedom

In the future, there will be robots: How to Pick Great Stocks

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!

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Financial Freedom

10 Rules For Investing: Violate them at your own risk

I’ve had a lot of lessons over the last 14 years of investing. Some of these were learned the hard way (losing money) and some paid me. The key is to understand what you’re doing right/wrong. I find it important to have a set of rules so you don’t make stupid, irrational, emotion-driven decisions. 

  1. Over the long run, the market beats professional fund managers (and you)
  2. Time in the market beats timing the market
  3. Add to your positions when opportunities present themselves (buy the dips) 
  4. Stocks will be higher in 10 years than they are today 
  5. When stocks go down, they get less risky
  6. Only sell a stock if it no longer fits the reason you bought it
  7. Stay away from IPO’s, Penny Stocks, biotech, and options (unless you know what you’re doing) 
  8. The market is NOT efficient, and that’s okay
  9. Don’t forget, if you lose 50%, it takes 100% to get back to where you started.
  10. Invest in companies you believe in, and understand how they make money
  11. Bonus rule: Follow the rules and don’t get greedy

1. Over the long run, the market beats professional fund managers (and you).

This is rule #1 for a reason. You cannot expect to consistently beat professional fund managers, and they can’t even consistently beat the market. You may have good years where you kill the market (like most people in 2020), but don’t believe it’s because you’re some kind of stock-picking genius. Over a 15 year period, the S&P 500 beat 92% of actively managed funds. Especially considering that those managed funds are going to charge you 1-2% in expense ratios, where an S&P 500 Index ETF is going to charge you 0.03% (VOO). My advice is to put 90% of your portfolio in an index fund, then use the rest for stocks you love.

2. Time in the market beats timing the market.

Don’t try to time the market. You will miss out on the biggest moves because unless you’re a time traveler you have no idea what’s going to happen. Consistently buying over time beats trying to time the highs and lows. Own an index fund, and to it weekly, biweekly, or monthly with new investment $$. This is called Dollar Cost Averaging. Never sell it because you think the market is too high.

3. Add to your positions when opportunities present themselves (buy the dips)

Despite the last rule, there are times where an opportunity presents itself. A market crash or market correction usually creates a buying opportunity. It typically seems like the scariest time to buy, but volatility creates a lot of opportunities. If you have a long term lens, it will be worth buying more.

4. Stocks will be higher in 10 years than they are today

This one is probably controversial, and there are no guarantees. That being said, the market is always recycling the companies in the S&P 500, the losers fall out and new companies come in. We’ve also seen that the US government and Federal Reserve are basically willing to write a blank check for keeping the markets pointed up and to the right. Inflation alone will push stocks higher with everything else being equal. If you don’t believe me, look at a chart of the S&P 500 over the last 100 years and count the number of 10-year periods that stocks when decreased and didn’t rebound. Then count the # of times the market didn’t rebound in less than 2 years.

5. When stocks go down, they get less risky

This is typically a difficult concept for people to understand but think of a stock as the market’s perception of the value of a company. Everyone is trying to value the underlying company. At the beginning of 2020 Tesla shares skyrocketed to almost $1k per share. I thought I missed my buying opportunity [ENTER COVID] The stock crashed about 60% in March of 2020 and I scooped up shares one day off the bottom. I thought the stock was too risky at $1k, but even with a global pandemic the 10-year growth story for Tesla was one I wanted to bet on. 

6. Only sell a stock if it no longer fits the reason you bought it

Ignore the noise around a stock unless it fundamentally changes your justification for buying it. I typically have a 10-year view of any stock I buy. I look at industry trends, find the companies best positioned to own that trend, and invest accordingly. 

  • I’ve owned Apple for years and will continue owning it because of the massive cash flow they have. I am confident it will go up because I don’t see any major threats to their ability to generate cash flow (if anything Mac and services will continue growing). I also know that they are going to continue buying back shares aggressively with their cash flow. So either: the stock goes up, or they buy back shares at a good value share price, which makes my shares more valuable. Back in September 2020, dropped about 23% because analysts were underwhelmed by the event they had for iPads, and the iPhone 12 was delayed a month. I view this as a correction because the stock had outpaced reality, and was coming back down. I actually bought more, and am happy it went down because Apple can buy back its shares more effectively when the share price is lower. A 10-year lens makes you think like an owner, not just an investor. 

7. Stay Away from Shiny Objects: IPO’s, Penny Stocks, biotech, and options

This is a big one because right now there are some huge IPO’s coming out. 

  • IPO’s – The whole point of an IPO is for the company to raise a ton of money at one time by selling a portion of the company’s shares. The perfect IPO would end the first trading day at issue price because that means the company maximized the cash they could have received from their IPO. DASH recently had an IPO, which started out up 80% – that means they could have gotten 80% more money for the shares they sold than they did. Or they could have sold a lower % of the company shares with an issue price of 180. It’s really a huge miss if you are the company because you are selling the company for $102 when people are willing to pay $180. I’m not blaming the company, there was a lot of dumb money thrown at this IPO.
  • Penny Stocks – There is a reason they are worthless. Don’t let their fluctuations tempt you. The reason why is the spreads suck, liquidity sucks, and there are a bunch of suckers also trying to make money. There could be a day they are up 100%, but nobody out there is going to buy it from you (liquidity)
  • Emerging markets (electric vehicles)/Biotech/speculative(Ex: Marijuana) – Biotech can be huge but requires a lot of approvals which can go south. Emerging markets have a lot of players that can skyrocket, but every industry has consolidation. This means at some point, the electric car industry which has a ton of startups right now, will consolidate to the top 2-3 that are actually going to have sustainable businesses. The rest will go bankrupt or be purchased for intellectual property.
  • Options – Options are great. They can be a great way to hedge risk. Or make a bet on volatility. There are countless strategies in derivative markets, but they also carry a lot of risks if you don’t understand them.

8. The market is NOT efficient, and that’s okay

There is a hypothesis that the market is efficient, meaning the stock prices in all available market information and values it appropriately. I disagree because it doesn’t factor in human emotion and irrational exuberance (stock bubbles). Tesla is the clearest example of this as of right now. Almost everyone believes Tesla is overvalued. It’s currently valued at over $600B, more than every other auto company combined. It is basically pricing in 5 years of perfect execution and market expansion, along with the belief that it will transcend the traditional automotive business model. I strongly believe in the company, which is why I’m not selling, but I wouldn’t add shares unless it drops 50% from the current valuation. The fact that the market isn’t efficient creates opportunities everywhere -rallies are higher than they should be, crashes are deeper than they should be. Bad news hurts stocks in the short term, but in the long term is just noise. Don’t let the noise dictate your investment strategy.

9. Don’t forget, if you lose 50%, it takes 100% to get back to where you started

Compounding growth is the goal – and with compounding consistency and time are the most important ingredients. This is a marathon, not a sprint. 

10. Invest in companies you believe in, and understand how they make money

Don’t follow the trends of the hottest stocks. Buy stocks for companies you use most. If you’re putting your own money into something, you’ve determined it’s worth your money as a consumer. Why wouldn’t it be as an investor? You also need to know how they make money or will make money in the future. What is their value proposition? I personally only invest in companies I believe are #1 or #2 in their industry. 

Bonus rule: Follow the rules and don’t get greedy

If you follow these rules, you won’t have the 10,000% gains in a year people talk about because they bet on a penny stock that actually worked out. Follow these rules and you will be able to provide consistent returns with moderate risk. Your balance also won’t go to zero.

Another bonus

Make sure you apply the filters below before investing. The investment must hit all 4. Today was the IPO for Airbnb. Despite rule #7, I was prepared to invest if the price was right. It wasn’t even close, to my target, so I’ll have to wait. I may never own it if I can’t justify the price. I will go into how I value the fair value in a different post.

Munger’s “Four Filters” for picking a company to invest in

  1. Understand the Business
  2. Sustainable competitive advantages
  3. Able and trustworthy management
  4. Price that affords a margin of safety (sensible purchase price)

Are there any rules I need to add to my list? Leave a comment below!