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Friday, October 21, 2011
It's no wonder investors are having such a hard time right now...
Most people buy stocks with the idea that their share prices will go up by 20% or 30% in a year, allowing them to sell relatively quickly with a healthy profit. They truly don't understand the concept of compounding returns or why anyone would want to hold the same stock for decades.
The reason you want to own common stocks is that (ideally) they grow their earnings over time and increase the amounts of their payouts to investors. Reinvesting these payouts (in either the same stock or others) allows you to greatly increase the return from your equities over time.
Increasing earnings and dividends also protects you from inflation – even better than gold – but only if you buy the right kind of stocks... and only if you pay the right price.
I'll show you exactly how to do that today...
As I explained yesterday, you need to look for capital-efficient businesses, like Hershey and Coke. The best part about buying these kinds of stocks is the rich payouts to investors.
These companies operate consistent, global businesses. They will continue to pay their dividends and make share buybacks... whether the euro disintegrates... whether the U.S. dollar is devalued... whether we go to war with Iran, etc.
Their stability and the size of the payouts allow you to judge the success of your investment by the capital you get back from the company, instead of merely the share price.
This will enable you to withstand the volatility we'll likely experience over the next several years.
Take Campbell Soup. It's been making roughly the same amount of money (about $3 billion in gross profits) in each of the last three turbulent years. That doesn't sound like much growth – and it's not. Likewise, the share price hasn't moved much over the last five years. It's just bounced around between about $25 and $35.
That doesn't sound very good, does it? But then, factor in this...
Last year, Campbell Soup returned more than $1 billion to its shareholders in the form of cash dividends and share buybacks. The company's entire market cap is a little more than $10 billion. So in terms of return on their investment, shareholders earned about 10% over the last year. Plus, as the share count is reduced, the stock they own is worth more and more as a percentage of the total. If this keeps up for a few years, sooner or later, the share price will soar, as will the value of the dividends being paid.
If you're making 10%-20% a year in the form of capital distributions, you quickly learn to ignore the ups and downs of the share price, especially when you own an asset as stable and efficient as Campbell Soup.
That's real investing. That's exactly how you do it – over the long term, with super high-quality companies you've bought at a good price.
Of course, there's the key: a good price. For my most recent Investment Advisory issue, I created a simple list of high-quality, capital-efficient companies that are trading at or near a reasonable price.
Here's a sample:
The first column shows the company's capital efficiency over the last 10 years. Out of all the money it made in gross profits, what percentage was distributed to shareholders?
The second column is a modified version of the price-to-earnings ratio, which simply tells you how many years of a company's cash from operations it would take to buy the entire company (including its debt). In general, we are seeking to buy these kinds of companies for less than 10 years' worth of cash earnings – although that's sometimes adjusted to account for significant amounts of future expected growth.
Finally, the last column shows you the company's latest annual return on assets (ROA), which is a measure of the company's overall profitability.
As you can see, while most of these are trading at reasonable prices... none of them is cheap.
So even though I want to own most of these businesses... I wouldn't recommend buying any of them today. I'd recommend you simply become familiar with the basics of those companies above and others like them. Read their annual reports. Follow their progress. Keep an eye on their share prices. Decide on the price you are willing to pay. Again, you're trying to get these companies at prices around (or below) 10 times current cash earnings.
When the panic arrives, you will be prepared to buy.
Of course, it's one thing to say "buy good companies when they're down." But it is quite another thing to actually do it. It's much, much harder than it looks. You have to overcome big emotional obstacles to buy when everyone else says, "sell."
You've got to be certain the company is sound and is going to be around for a long time. You need to be sure the company you're buying will maintain its capital efficiency. And you, the investor, must have the financial ability to hold it for a long time.
Ideally, you'd augment your savings with a handful of these kinds of great investments. It doesn't take many. I'd recommend investing around 25%-50% of your liquid assets into a program of disciplined, high-quality investing.
If you buy these stocks at the right price and reinvest the dividends, you'll see the size of your holdings grow substantially over the long term.
Yesterday, Porter introduced readers to capital efficiency, one of the most important factors of investing. In times of crisis, capital-efficient businesses "will provide an excellent hedge against inflation – even better than gold." Learn more here: The Best and Most Surefire Way of Building Wealth in Troubled Times.
"Their balance sheets are financial fortresses. Their businesses are incredibly difficult to compete with," Dan Ferris writes. "They earn consistent profit margins, a sign of their superior ability to compete." They're World Dominators. And they're the highest-quality companies in existence. Read more here: This Investment Is Safer – and Pays More Income – Than Gold.
A GOOD SPOT TO SHORT THE EURO AGAIN
After a brief "confound the crowd" rally, the euro is rolling over.
Regular readers know one of our top trading ideas for 2011 is to short the pan-European currency, the euro. While Greece gets all the "debt disaster" headlines these days, it's only a matter of time before the indebted, brittle economies of Spain and Italy pull the continent into a bigger crisis... and take the euro much lower.
Back in late August, we highlighted the euro's "compressed" state. This is a situation where an asset's day-to-day volatility gradually dries up and the highs and lows move closer together. These low-volatility periods are often the calm before a storm. We expected to watch the euro's compression resolve itself to the downside.
As you can see, the downside break arrived as expected. The euro plummeted from 1.45 to 1.32 (a giant move for a major currency). The end of this move drew in a lot of "fast money" traders looking to bet on a euro decline. And since the market loves to confound the crowd, it retraced a good portion of this rally. But that rally has halted at the 1.39 level. Equilibrium has temporarily been restored, and the euro is ready to head lower again.
In The Daily Crux