For most investors, the concepts of risk and reward are like two sides of the same coin. Most investment literature I read implies that in order to achieve exceptional returns, one has to bear exceptional risk. If one is seeking very little risk, on the other hand, one must be content with very low returns.
I believe that achieving reasonably high returns in equities does not have to entail accepting a very high risk of capital loss. Rather, I have become convinced that value-oriented investors can produce excellent investment records by concentrating on hitting singles and doubles and avoiding the home-run mentality that inevitably leads to lots of strikeouts, but which may or may not produce the required number of big winners to make up for them. I've personally found that the home-run mentality in investing leads to a great deal more strikeouts, but doesn't lead to many more home runs than a more risk-conscious approach.
I've come up with 15 guidelines that I hope will help you become a high-percentage investor, with the goal of avoiding the catastrophic losses that decimate your returns while increasing your success rate in identifying good stocks.
Of course, these are just basic guidelines, and they also incorporate my own personal investment biases. There are exceptions to every rule, and general guidelines don't apply perfectly in every investment decision. Also, keep in mind that there is a place in the market for investors who take on risk intelligently, the best of whom will be rewarded with returns that justify the assumed risk. But most people don't assess risk well, aren't prepared for the nasty side of risk, or just don't have the personality for it. This list is especially aimed at individual investors who want to build a portfolio of 10-20 stocks and are limited in both time and resources.
1) Buy Companies With Positive Free Cash Flow
Cash flow is what investing is all about, and ultimately, a company's market value will reflect its ability to generate cash. Free cash flow is the cash left over for the benefit of shareholders. If every company in your portfolio generates cash above and beyond what it needs to maintain and grow the business, the value of your portfolio as a whole should grow over time. I know this is basic folks, but that doesn't make it any less true. Be especially wary in cases where there are reported profits but no cash flow -- think Enron.
2) Find Companies with Demonstrated Earnings Power
Look for companies that have demonstrated the ability to generate consistent cash flow, year in and year out, through booms, recessions, and everything in between. When I say consistent, I don't mean perfectly smooth -- every business will have good years and bad years. But the bad years shouldn't be horrible, and some companies are pretty good even in bad years. These are the ones you want. Obviously, this means avoiding the stocks of many promising young companies that haven't been around long enough to have a track record.
3) Look for a Dividend
Here's something you may have never thought of about dividends, but a company that pays dividends is less risky for the investor than one that doesn't, all else being equal. Let's say, for example, that both Company A and Company B are going belly-up after five years -- a very bad scenario. But assume that Company A pays a 5% dividend, and Company B pays nothing. After five years, even if Company A goes bankrupt and the common shareholders are left with nothing, you will still have received five years of dividends, so you actually only lost 75% of your starting capital. With Company B, of course, you lose it all. Of course, companies headed for bankruptcy generally start cutting the dividend at some point on the way down -- an obvious warning that even the most time-pressed investor will notice.
While the worse scenario above is of course rare, receiving meaningful dividends over many years can make a huge difference in total return over time and can significantly improve long-term results. Not only that, but stocks that pay hefty dividends aren't as susceptible to huge percentage losses in market price, barring an absolute catastrophe, because the dividend yield helps to hold the price up.
4) Watch the Debt
Debt is risky, and the higher the debt in relation in shareholder equity, asset values, and the ability of a company to produce cash, the riskier the stock. On the other hand, it's pretty tough for a company to go bankrupt if it produces free cash flow and has no debt. On the opposite side of the risk spectrum, look for companies that have way more cash than they need to run their businesses -- such companies can withstand even the worst of economic storms, so long as their management doesn't do stupid things with the money. The risk-averse investor wants to own companies that will survive the 100-year storm, and debt-laden companies are the first to get washed away.
5) Beware of Serial Acquirers
Before you say it, Berkshire Hathaway (NYSE:BRK.A) is the exception, not the rule. Tyco (NYSE:TYC), Elan Corp (NYSE:ELN), and WorldCom are exceptions, too, but I'd bet there are 10 of those for every Berkshire. The problem with serial acquirers is twofold -- they generally overpay for their acquisitions and dilute their good businesses with those of lower quality (see my 2001 article on Koala Corp, (OBB: KARE) which is also a poster-stock for #4), or they use acquisitions as a masking agent for all kinds of accounting shenanigans that makes it hard for even the most experienced investor to determine what the true economics are. Be especially aware of companies that take on excessive debt for acquisitions instead of paying in cash or stock.
6)
Avoid Stocks With Too Many Moving Parts
This one is best explained with an example -- General Electric (NYSE:GE). I couldn't imagine being able to come up with a reliable fair value estimate for GE. There are just way too many moving parts, and the landscape changes so often that it's just not worth the effort. If there is anything ugly hiding in the cracks in a company of GE's size and complexity, most investors are never going to find it. And unfortunately, in a company of that size and complexity, the likelihood of something ugly existing is pretty darn high. Most importantly, an investor with limited time can assess five or 10 other companies in the time it would take to adequately research GE. That's reason enough to stick to simpler businesses.
Tomorrow, I'll present the rest of my guidelines for the risk-averse investor and add some finishing thoughts. If you don't think a two-part series will whet your apetite, consider our latest online seminar, Perfect Your Portfolio: Asset Allocation for Long-Term Wealth.
Zeke Ashton has been a long-time contributor to The Motley Fool, and is the managing partner of Centaur Capital Partners, LP, a money management firm in Dallas, Texas. At the time of publication, Zeke did not own any stock mentioned in this article. Please send your feedback to [email protected].
