OtOoI Ch. 5: Investment Strategies

OtOoI Ch. 5: Investment Strategies

We’ve covered a lot of ground to get to this point. We’ve learned about why we need to invest, which prompted us to learn more about the environment in which we invest (and the financial instruments we can use to do so), the mindset we need to have when investing, and what sorts of accounts we can put our money into.

Now that you have funded your investment accounts with hard earned savings (and plan to keep funding it with ongoing savings, right?!), it’s time to decide how you want to deploy that money to beat inflation.

Today, we’ll talk about investing with:

  1. Financial Advisors
  2. Conservative Investing
  3. Index Investing
  4. Value Investing
  5. Growth Investing
  6. Income Investing
  7. Short Selling

WARNING: This is another dense chapter, but reads like Twilight. Enjoy!

Financial Advisor

I’m not going to bother with too much explanation on this one. A financial advisor can be had at most financial institutions (your big box banks, as well as smaller investment brokerages).

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Figure 17. This is Brian; he’s trustworthy, and his job is to make you money, but not before he takes his cut for doing so. His wife and kids send you their regards!

There are many kinds of financial advisors, and they offer various services, from financial planning to portfolio management. They can be helpful in that they are typically certified*, and therefore know the business of investing.

Finding a financial advisor can be the most hands off investment strategy, as you simply provide the money, and an explanation of your plans, goals, and risk tolerance (usually determined by an interview and questionnaire). The planner does the rest.

They may utilize different investment strategies and philosophies to manage your portfolio, partially based on the answers to the questionnaire, and also based on your direction or preferences (if you have any of them).

Another major factor in what they may offer you is the bias they derive from their desire to make money for themselves.

Financial advisors work on many different models. Some work on salary and commission. They may receive incentives from mutual fund companies for selling you mutual funds; they may charge a percentage of your profits for the year or charge a percentage of your portfolio for managing it; others charge a flat fee for every trade they make (requiring your permission) on your behalf.

It’s important to remember that certain models of compensation for your financial advisor are better for you, and may be different based on your investment strategy. If you want someone who is more hands off, but still would like their advice and oversight, maybe paying them a flat fee for every trade would be better. If you want to be more hands off, you might find that paying them a percentage of your profits incentivizes them to produce superior results.

Ultimately, remembering that while their job is to make you richer, their ulterior goal is to make themselves richer. Understanding how your advisor is compensated is important to understanding how they work for you, the products they offer you, and the advice they give you.

*Do your homework and make sure they are. Key word would be ‘fiduciary’.

Conservative Investing

Buy bonds and GICs. Low risk, low returns.

I don’t mean to make this sound boring, but it is. Conservative investing can be safe, and in all honesty, it probably isn’t why you are reading this book.

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Figure 18Zzzz.

What I would like to offer you is that conservative investing should, and likely will, factor into your financial and retirement plan at some point. Why?

Because eventually our long term investment horizon becomes shorter (that’s how time works people), and our risk tolerance goes down.

While we may find that having the major proportion of our portfolio dedicated to equity (the higher risk stock market) in our youth, that proportion should diminish as we approach the time when we need to preserve our capital to draw on.

A general rule of thumb is that the percentage of your portfolio allocated to equities should be 100 minus your age. You can therefore imagine that as you age, you shift more of your holdings into safer, lower-risk bonds. You may of course, manipulate this rule to your desire, based on your perceived risk tolerance.

Doing this is a hedge against stock market volatility, which becomes more of an issue when you actually have a need to access your savings in your retirement.

Example: Calvin and Jim are both 60 years old, and have both been investing for their retirement. They both have portfolios worth $1,000,000. Calvin follows the “100-age” rule for equity allocation, while Jim has been more cavalier with his investments and left his entire portfolio in equity. The year is 2008 and the stock market dives 40%.

Calvin’s portfolio has 60% bonds and 40% equities. Due to the stock market drop, Calvin’s equities are now worth 24%. His portfolio has dropped 16%, and is now worth $840,000. Jim’s portfolio is 100% equities. His portfolio drops 40%, and is now worth $600,000.

When each withdraws $30,000 for their annual salary, Calvin withdraws 3.5% of his portfolio, while Jim withdraws 5%. The stock market rebound is dampened for Jim.

Conservative investing can, and should be a part of your retirement plan, but how you employ it is up to you, your goals, and your risk tolerance.

Index Investing

This is perhaps the second most (if not the most) hands off investment strategy. It is aptly named, Couch Potato Investing. So what is it?

The philosophy is based off of the Efficient Market Hypothesis. This is the idea that the market is smarter than your mutual fund money manager; that stock prices are generally fairly priced, and therefore, it is next to gambling to try and beat the market with stock picking. It holds the idea that over time, the nature of the global economy is that it gets bigger, and therefore, if you own a stake in the companies that participate in it (in fact, own a fraction of a stake in an enormous number of those companies), your investment will grow with the economy.

world in hands
Figure 19. Hold the world’s markets in your hands, or in your portfolio. Or both.

The practical way that this is done is by purchasing index-tracking ETFs. As mentioned in the section on funds, ETFs are the chosen vehicle because of the objective evidence that the majority of mutual funds do not outperform the index and yet charge higher fees. Index-tracking ETFs, by definition, perform on par with the market. If the market grows by 8%, so does your portfolio (minus fees).

Typically, you can find a combination of ETFs that track indexes in various markets (for example, tracking the S&P TSX, the S&P500, and then funds tracking international or developing markets). You will apply a certain percentage of your portfolio to each ETF. This way, you are giving yourself Super-Duper™ diversification, because not only are you diversified within a single market, but you are diversified within different global economies. If the Canadian market is taking a pounding, and the American market is booming, your portfolio remains relatively stable.

If you want to set it and forget it, this may be the strategy for you. Your portfolio will need to be rebalanced at least once per year to maintain the appropriate allocations to your various ETFs. This ensures you do not become overbalanced in any one market, preserving your beloved diversification.

Example: Harriet is a Canadian Couch Potato with $40,000 in her TFSA. She has an assertive approach to ETF investing through ETF provider Vanguard, with 25% of her portfolio in Canadian Bonds (VAB), 25% in Canadian stock (VCN), and 50% in the international stock market (including U.S., excluding Canada; VXC).

The year is 2017 and the Canadian market has tanked 10%, while the global market has rallied 5%. VCN is therefore now worth $9,000, (25% of $40,000 is $10,000, less 10%) while VXC is now worth $21,000 (50% of  $40,000 is $20,000, plus 5%).

At year end, she sells some VXC (at 52.5% of her portfolio) and buys some VCN (at 22.5% of her portfolio) to rebalance back to 50% and 25% respectively.

You can learn more about index investing, including model portfolios at The Canadian Couch Potato website.

Stock Picking

Stock picking is probably the investment strategy that you immediately picture when you think about the stock market. You are a genius, watching the markets, assessing individual companies, buying a stake in them when they are undervalued, and then getting out after they surge in price to double your investment.

Some people have had success doing this. It is associated with a great deal of risk, as it usually entails buying a stock that is discounted with the hopes that the stock price will rebound. The difficulty with stock picking is that opportunities can be created by the emotional lability of the investing populace, but one can also be burned by this emotional lability. Buying stock, especially those below $5-10 a share (or worse, below $1) have the highest potential for enormous gains (because a $0.10 rise in stock value is a far more significant on 400 $1 shares than a $0.10 rise on 10 $40 shares; $40/10% profit vs. $1/0.25% profit). For the same reason, they have the highest potential for enormous losses.

There are many strategies within the realm of stock picking, some more risky (and more akin to gambling) than others. These strategies can also be employed effectively for business ownership, or going ‘long’ on stocks rather than speculating in fickle markets. I will outline some of these stock picking strategies here.

1. Value Investing

This involves assessing a company’s fundamentals (revenues, expenditures, earnings, liabilities, book value) and determining the actual value of a company’s stock. This inherent ‘value’ may be based on strong earnings, or a great dividend, or a strong base of tangible assets. The value is then compared to the actual price, and the investor makes a judgment as to whether the stock is under- or over-valued. 

Essentially, a value investor relies on the idea that a company has some rational value, but that the price is set by irrational investors. By trying to be as rational as possible (investing based on fundamentals, or evidence), the investor can capitalize on opportunities when investor sentiment undervalues a company with strong underlying value.

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Figure 20. Warren Buffett is a classic example of a value investor. He buys companies with strong fundamentals, and holds them.

This can be a successful strategy, but relies on the irrationality of the market to find opportunities, and also requires a good deal of numbers work to identify where value is. Additionally, the strategy is contradicted by the Efficient Market Hypothesis (essentially the basis of index investing), that markets are efficient and therefore the price of most companies in the market are fairly priced based on their value.

There are shortcuts for value investing, like looking at P/B ratios to identify companies with strong concrete value compared to their price, or PE ratios to identify those companies that have higher earnings compared to their price. These ratios can change based on a number of different variables, and therefore it is usually recommended to  look a little closer at the numbers behind them.

Example: Hi, Inc (HI). is a wireless telecommunications company. The average P/E ratio in the sector is 25, but due to the entry of a competitor into HI’s key operating region, investors are concerned about the company’s long term prospects, driving down share prices and discounting them to a P/E ratio of 15.

Despite concerns over reduced profits due to increased competition, the regulatory environment remains favourable for HI, and projected earnings remain solid even in the context of increased competition. There is value in HI due to these strong fundamentals, and the stock can be had at a bargain relative to the industry average P/E.

2. Growth Investing

Again, this strategy requires looking at the fundamentals of a company, but from a different perspective. The growth investor identifies companies that have a trend of earnings growth due to expanding market share, good products, and efficient management. 

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Figure 21. Thomas Rowe Price is considered the father of growth investing.

These companies may be priced fairly, or even highly now (based on their current earnings), but are underpriced today in relation to the long term, as they are companies that will grow (increasing their earnings), and therefore increase their value.

The assessment of a company’s capacity for growth starts with a look back at it’s historical growth, and then an appraisal of the company’s projected growth for the next five years. These projected growth figures are established by analysts, and the data behind their projections should be carefully considered within the context of the company itself, and the industry in which it operates.

Another important factor to consider is whether the company’s management efficiently control costs, allowing growing profits to translate to higher bottom line earnings (this is called profit margin**), as well as its efficiency in generating profits from its underlying equity (this is called the Return on Equity***).

Growth companies rarely pay dividends as their goal is to retain profits for re-investment in the firm, allowing it to grow that much faster.

The rule of thumb for effective growth investing is to invest in companies that will double in size within five years, which predicates a 15% annual growth rate in the company. This is the growth rate you will be looking for in the analysts’ predictions.

The downside, of course, is that the predictions are just that: predictions. You cannot be sure that the company you have chosen will double in value in the next five years,  otherwise all of us would be growth investors and all of us would be very rich.

Example: Jimmy’s Coffee (JMY) has an IPO, resulting in shares priced at $30. Annual earnings are currently $2 per share, giving JMY a P/E ratio of 15.0, which is considered a fair ratio in the coffee market.  With this newly invested capital, Jimmy’s management initiates a plan of rapid expansion. Analysts predict growth in earnings of 15% per year.

In five years, sales have doubled and costs have been quartered by astute management and economies of scale. As such, earnings have tripled to $6 per share. Given a fair P/E ratio of 15, each share is now worth $90, and has also tripled in five years. This company is an outstanding growth company and you are very satisfied with yourself for seeing its potential.

This strategy also falls prey to the efficient market hypothesis; that growth is a desirable trait and therefore the current market price reflects potential for growth. An example would be Tesla Motors, which is highly valued despite negative earnings because of obvious growth potential in the long term.

**A company with a high profit margin produces more profit (net income) as it has fewer costs to eat away at the company’s gross revenue. It is a more efficient company at translating pre-cost income into post-cost earnings.

***A company with a higher R.O.E. produces more profit with less equity (money invested). It is a more efficient company at turning invested money into net income, meaning a higher percentage of every dollar invested produces profit.

3. Income Investing

Income investing stands in stark contrast to growth investing, in that it typically involves purchasing companies that are well established in their fields, with fewer opportunities for growth, but steady earnings and solid business. For mature companies, there is a decreased capacity for growth, leading to diminishing returns for each dollar pumped back into the company. Instead, they pay dividends to their shareholders out of the earnings.

The key consideration in income investing is the dividend yield, which is a figure that immediately tells you how much of a dividend you can expect for your dollar invested.

Example: Royal Bank of Canada (RY) costs $70 per share, and pays an annual dividend of $3 per share. $3/$70 is 4.28% dividend yield. For every dollar invested, RY pays you 4.28 cents, which you may take as profit, or apply towards the purchase of more shares (see below).

It is very simple to find dividend information on any financial website, but the dividend yield is not the be-all and end-all of income investing, as the investor must assess the sustainability of the dividend’s payment, which comes from the company’s profits. A key figure to consider in its sustainability is the dividend pay ratio, which is a measure of the yearly dividend per share divided by the earnings per share (EPS). A company with yearly dividend per share higher than earnings per share is not sustainable forever (though it is possible as the dividend can be paid out of the company’s cash savings; this strategy is often employed to avoid dividend cuts when a solid company is going through a rough patch).

Income investing is not any less risky than the other investing strategies, though risk can be mitigated by considering which companies you are purchasing. As mentioned above, many of these companies are large, well established, strong companies that are unlikely to go under, and therefore reduce your risk for loss of capital. They are, however, still susceptible to market volatility.

A benefit of Canadian dividend paying companies is that for Canadian investors, the dividends are tax preferred. You will pay a lower tax rate on dividends from Canadian companies than from American or international companies.

Ultimately, this can be a solid way of investing, with lower risk (due to the reliability of the companies), and returns that are simple to predict (each company typically announces its yield, so you can know exactly how much money will be coming in each year from your holdings), while appreciation in stock value is another consideration.

One final note for income investing is the consideration of dividend growth. A company that is able to increase its dividend yearly signals a strong company with strong fundamentals. Dividend growth is a hedge against the impacts of inflation, and also adds value to the stock; companies that grow their dividends are more highly valued, and therefore also grow in price. Assessing a company’s dividend growth is a key component in picking any stock for an income portfolio, and historical dividend growth can be found online. In a way, this blends the concept of growth investing with income investing.

Dividend Reinvestment

An added feature for dividend paying stocks is that many of these companies offer what is called a Dividend Re-Investment Plan (DRIP).

A DRIP is an offer by the company to pay the owed dividend partially in cash and partially in stock. The company will often incentivize this process by offering some discount on the stock, as it allows them to keep more of their cash on hand for expanded operations. Every stock purchased with a DRIP increases your next dividend payment, as you will have more shares paying dividends. This grows the output of your portfolio, along with the overall value of the portfolio (because you have more shares!).

Example: Toronto Dominion (TD) shares cost $50, and pay a quarterly dividend of $0.50 (annual dividend yield of 4%). TD offers a DRIP giving you a 2% discount on shares purchased through the DRIP.

Your portfolio holds 200 shares in TD, giving you a quarterly dividend of $100. This purchases you 2 new shares of TD ($98, at $49 each, a discount of 2%), along with a $2 deposit for the remaining cash owed. Your next quarterly dividend will be $101 (two new shares paying $0.50 per quarter).

The other added benefit of a DRIP is you expand your holdings in the company without being subject to trading fees (anywhere from $7.99 and up per trade), allowing you to grow your portfolio while minimizing costs for You, Inc. Your portfolio becomes a self-growing machine, as the profits it generates grows the contents of your portfolio, not just the value of each share.

Finally, when you retire, or at any time for that matter, you can cancel your DRIP and start withdrawing the dividends as income… hence, income investing.

4. Short Selling

Short selling is an investment strategy based on pessimism. It is a way to make a quick buck, and can be extremely risky. The reason that it is a fast way to make money is because it is literally the practice of holding a stock for a short period of time, or shorting the stock (whereas most investors using the above strategies are ‘long investors’).

The short seller ‘borrows’ stock from a brokerage and sells it at a certain price, then buys the stock back after a drop in the stock’s market price. The difference in the price between where it was sold on the short, and then purchased back at a lower price, is the profit from the short sale.

Example: Dairy Queen (DQ) shares are priced at $20. The short seller believes that shares of DQ are over valued, and are due for a correction.

The short seller borrows 500 shares of DQ stock from their broker at a cost of $10,000. While borrowed, the short seller services the loan of stock with cash payment.

DQ declares a drop in its quarterly earnings prompting a selloff that drives share prices down to $15, at which point the short seller buys back 500 shares at a cost of $7,500 to cover their stock loan to the brokerage, taking a profit of $2,500.

If this is confusing to you, don’t do it.

Conclusion

The approaches listed above are only four in a huge array of others, some variations on those I’ve outlined, others combinations of the above, and others based on completely different philosophies.

Within your portfolio, you can choose to pick some stocks based on value, others based on growth, others based on income, and others based on anything else you find to be intriguing.

You may occasionally be able to find stocks that are a good value and also have promising dividend growth. This is the approach I typically use; looking for solid companies that are discounted on the year (usually around its 52 week low), that have a history of rewarding their shareholders with growing dividends. I then establish a DRIP for each, and watch my portfolio grow without the tether of fees.

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Figure 21. Build your own retirement savings machine.

This approach is ideal for the person who is investing large lump sums (for example, topping up a TFSA contribution, or investing a tax return or bonus) as you can cut down on expenses by minimizing your trades. Additionally, it requires minimal oversight as it entails buying and holding strong companies for long periods of time. It is a portfolio growing machine, as over time, my stake in each company increases, increasing my dividends, which increases my portfolio’s capacity for self-reinvestment. In retirement, I plan to cancel my DRIPs and draw on the dividends my portfolio generates as quarterly income. This strategy may not be perfect for you. For me, as a busy medical professional, it is ideal as it lends itself to hands off, lower-risk investing, in my opinion. Despite this, it still affords me oversight and control (which I obviously value).

The underlying philosophy is that of business ownership; I provide equity for the companies I involve myself with to carry out their operations, and they reward me with steady profits in cold, hard cash.

Today, we concluded our 5-part series on investing as a means of saving for retirement. We discussed more hands-off investing (financial advisor-driven, conservative, index investing), and more active investing (value, growth, income) strategies. There are many other ways of investing, but I hope that you now have the tools to explore them yourself!

What I would encourage you to do is look for different techniques that work for you, philosophically, and based on risk tolerance. Your portfolio can, and should be a growing and changing entity. Don’t be afraid to start small and learn by trial and error. The beauty of starting early is that you have lots of time to make good on your mistakes.

There is a whole world of finance for you to discover, and I hope I have equipped you with the basic tools to understand and keep learning. Refer to the following glossaries (published tomorrow) for a review of some of the key terms presented in this series.

Keep your eyes out for features in the future on other aspects of finance pertinent to young professionals (incorporation, tax planning, mortgages, etc.). I hope that you have found this series useful, and am happy to answer any questions you may have. 

And to your future self, Happy Retirement! And of course,

Happy Living,

JRM

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