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Investing with Purpose

Ron Watkins

March 20, 2003

 

In January 1970, Bob and Jim decide to invest $100 per month into the S&P 500. But Bob buys every month at the peak close; Jim buys every month at the lowest close. Neither sells any shares. By the end of 2002, how much more money does Jim have than Bob?

A. Jim has 6% more money than Bob
B. Jim has 36% more money than Bob
C. Jim has 72% more money than Bob
D. Jim has about 2 times as much money as Bob

Think about this before reading on.

Answer:

In this scenario, Jim is a "perfect" market timer, buying at the low for every month for essentially 33 years. Bob on the other hand, is the "worst" market timer. So why isn't the differences between their outcomes bigger?"

As you could surmise from the sentence above, the answer is A.
The intention of the introduction above is to cause you to pause and think about your own philosophy, investment plan, temperment and ideas which cause you to take action. "Having a sound investment plan is the key prerequisite to successful long-range investing."

The following is the foundation of a letter previously written by the noted investment counselor, David L. Babson.

As geopolitical and economic forces cause action by market participants, many investors are now asking: "Where do we go from here? So this is an appropriate time to review the importance of developing and maintaining a sensible long-range investment plan.

Having such a plan, and holding to it, is just as crucial to creating a good portfolio as it is to building a solid house or establishing a successful business. And almost any plan is better than no plan at all.

Yet it is surprising how few investment portfolios are based on a consistent philosophy aimed at meeting long-term objectives. Most are merely collections of securities assembled over time for a variety of reasons which seemed compelling at the moment of purchase but are no longer clearly remembered.

Even among those investors who develop a basic plan, far too many do not stick with it through thick and thin. In periods of pessimism, they end up selling stocks when they should be buying. And when optimism prevails, they become lured by rumors, greed or bad advice into speculating when they should be investing. Being led astray by emotions can be avoided if the investor first asks some basic questions. How should he or she draw up a plan? What considerations should be followed in selecting suitable holdings? What attitude should be taken when market psychology swings from optimism to pessimism, or vice versa?

Long Range Planning

One of the biggest obstacles to good investment results is the widespread tendency to place too much emphasis on the short-range outlook. At times, the vast majority of investors seems to believe their whole future is wrapped up in the headlines of the day. and they perceive the high road to investment success as "buying low and selling high" and repeating the process over and over.

All the publicity given to share price fluctuations, to short-term changes in earnings, to temporary developments and to the shifting of big chunks of money from one issue to another by investment institutions, tends to create an impression that the stock market is just an enormous casino rather than a genuine public auction of capital assets.
Yet when attempted repeatedly, the buy-low, sell-high approach is bound to produce poor -- even disastrous -- results. This is because it requires an extremely rare combination of shrewdness, courage, independence, timing and luck that no human being can hope to muster consistently.

A further drawback to this approach is that it causes investors -- whether individuals or institutions -- to be preoccupied with the daily stock numbers. This can prevent them from doing the one thing that is certain to lead to good results -- establishing a sound long-range program suited to their financial needs and obligations.

As a starting point, all investors ought to realize that their own goals may be vastly different from those of others -- the widow next door, a golf partner, an alma mater or their employer's retirement fund. A 45 year-old business executive whose highly taxed earnings exceed his living expenses is obviously not in the same boat as a charitable endowment which pays no taxes but requires all the income it can obtain.

So each investor -- institutional or individual alike -- should arrive at a clear understanding of what he expects to accomplish with his capital. Is it to be a source of income 10 or 20 years hence or is it to carry the main burden of paying today's bills? Between these two extremes lies a varying range of long-term investment needs and goals. The next step is to choose the best means of meeting those objectives. The investor should carefully weigh the pros and cons of fixed-income securities versus common stocks and determine the appropriate mix for his portfolio. Age, temperment, tax bracket, current expenses, retirement needs and estate planning must all be taken into account.

Finally, the investor should decide upon a long-range approach which makes sense and with which he is comfortable. He should also establish an overall diversification goal. This should give a realistic weighting to the most favorably situated industries and companies relative to the portfolio's basic purposes.

The vital fact to be borne in mind is that building up one's assets is a project that spans a period of many years. If the stocks held are those of strong, expanding companies, history shows that the rewards of investment in their long-term progress will be surprisingly large in the end.

Common Stock Selection

The investor should recognize that the characteristics of companies differ greatly. Some offer below-average growth but a high dividend yield. Others provide moderate growth and more cyclicality. Still others combine a strong and fairly consistent growth of earnings with a low current return.

In the 90's, shareholders who have concentrated in growth companies have enjoyed excellent results. Superior earnings progress does not arise out of
thin air. Rather, it stems from underlying corporate attributes such as:

-- above-average demand growth
-- a dominant or leadership position
-- heavy emphasis on research and/or new product development
-- high return on invested capital
-- substantial plowback of earnings to finance future expansion.

Recent years,however, have caused many investors to forget their fundamental goals and plans, and to chase performance or alternatives. Even some very astute planners have shifted assets recently into bonds or the money market and while on the surface, they can accurately rationalize this decision ("Look at my return on my 5% bond vs. your 15% loss ! look at what your investment has to accomplish to make up this difference"), what they fail to realize is that common stocks have "always" made up this difference throughout history regardless of bear or bull markets and economies.

This is because, whether large or small, high-caliber companies with a leading position in growth markets have the ability to exert control over the prices of their services or products. Under good management, this enables them to realize a consistently high return on capital and finance an above-average rate of expansion. All of which leads to superior long-range earnings progress. This will always attract or re-attract investment capital.

In times of great growth like the 90's, the investor had to remind himself that even though his portfolio has a higher market value than it did 6 months ago, its ownership position has changed very little. If he has pursued a steady course, he still owns basically the same number of shares in the same companies as before. The investor at this time must be on guard to resist the 'smart money' talk that becomes all the rage with the stock market is booming. He should not be swayed into buying issues that are off the beaten track and do not fit into his overall strategy. His stocks are worth more primarily because other investors have become willing to pay more for each dollar of earning power than before. Price-earnings ratios tend to fluctuate and no one has the ability to predict their future levels.

In times of economic contraction, the investor must remind himself that he has an "opportunity" to add to his holdings of fundamentally sound companies. He must be on guard not to chase alternative returns and performance. The basic purpose of owning common stocks is to share in the growth of the earning power and the dividend-paying ability of the underlying companies. This is as true today as it was when the Dow Average was substantially lower. What the price of a stock or group of stocks does over the period of a week, a month or even two years is not the key issue. Of far greater importance is how much its earnings or dividends can expand over the next five or ten years.

Sticking to that long range plan can prevent the investor from making another common type of error -- selling a suitable stock because its earnings suffer an unexpected drop or because it runs into one of the slow periods that occur for even the best-managed companies. Have a plan gives him the patience to hold onto the right stocks through recurring bouts of unpopularity. Building a well-balanced portfolio that fits the investor's needs and objectives seems like a simple task. Actually, it is quite difficult. This is because it requires great self-discipline to continue with the program originally laid down and not to become sidetracked when market conditions change.

With a healthy investment attitude, however, the investor who bases his approach on holding a "part-ownership" in companies with favorable investment characteristics is following a sensible longer range plan. It is a proven strategy which produces good results over a period of years. It should be clear at this point that a rising or lowering tide affects all boats. In my past communiqué' I presented an example of three investors' decisions:

a) hold-but stop investing,

b) hold and continue investing,

c) sell-get out

The differences were enlightening. Just as the differences between the perfect market timer and the worst market timer in the introduction. It has always been my approach that the foundation of all investment portfolios follow a proven, consistent, longer term strategy -- and continuation of that strategy through consistent periodic investments. More established investors have the ability to seek higher returns, expose themselves to increased volatility -- but this point needs to be clear -- that this "expansion" into another investment or even speculative arena needs to have its own strategy and must not affect his or her previous long term foundation and plan.

It is my observation that most cannot keep these philosophies separate -- but failure to do so will more than likely result in heavy losses. Given current market conditions, valuation and geopolitical/economic climate however -- not only do I view this as an opportunity to firm up a solid investment foundation -- but I also see opportunities to participate in alternative investments which now have reduced risk due to the valuation of the market as a whole, diversification and trends. I mentioned a couple of such ideas in a previous letter. No they are not for most. No they are not speculative plays or trades. They are solid strategies which when followed consistently, through thick or thin, reward the true investors with superior results.

From George S. Clason in his book "The Richest Man in Babylon"

The Five Laws of Gold:

I. Gold cometh gladly and in increasing quantity to any man who will put by not less than one-tenth of his earnings to create an estate for his future and that of his family.

II. Gold laboreth diligently and contentedly for the wise owner who finds for it profitable employment, multiplying even as the flocks in the field.

III. Gold clingeth to the protection of the cautious owner who invests it under the advice of men wise in its handling.

IV. Gold slippeth away from the man who invests it in businesses or purposes with which he is not familiar or which are not approved by those skilled in its keep.

V. Gold flees the man who would force it to impossible earnings or who followeth the alluring advice of tricksters and schemers or who trusts it to his own inexperience and romantic desires in investment.

Ron Watkins