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Using Competitive Advantages to Find High Quality Businesses

My name is Brian Bollinger, and I am the founder of Simply Safe Dividends, a website that helps individual investors responsibly build and manage their dividend portfolios.

Prior to starting Simply Safe Dividends, I worked as an equity research analyst at a multibillion-dollar investment firm that actively managed several equity funds. I am also a Certified Public Accountant.

competitive advantages

My favorite part of my job is helping individual investors learn more about the art and science of investing, and it’s obvious that Andrew shares my passion.

While my focus is on investing in dividend-paying stocks, my investment philosophy and research process share many traits with other types of investing.

My Investment Philosophy
I do my best to adhere to a simple and conservative investment philosophy, which begins with sticking to investment opportunities that I can fully understand.

Warren Buffett refers to this as one’s “circle of competence,” and I have learned over the years that my circle is not very large!

There are over 10,000 publicly-traded stocks out there, but a reasonably diversified portfolio doesn’t need more than 20 to 40 holdings in most cases.

Since we can afford to be picky, the first line of discipline I follow with my philosophy is avoiding confusing businesses and industries.

If I can’t quickly figure out how a company makes money and why it might have some staying power, I move on. Many businesses are too complex for me, creating unnecessary risk.

After finding a company that I feel I can understand well, the real work begins. Like many other investors, I try to buy high quality companies when they trade at reasonable prices.

But what exactly does “high quality” look like?

In my opinion, high quality businesses possess the following characteristics:

• Time-tested operations
• Reasonably diversified by products / customers / end markets
• Large end markets with at least moderate long-term growth potential
• Consistent free cash flow generation
• Above-average and stable returns on invested capital
• Healthy balance sheet metrics
• At least several enduring competitive advantages that I can fully understand and believe in for the long term

Identifying advantaged businesses is very difficult and often involves a number of judgment calls.

How to Identify Competitive Advantages
According to Professor Richard Foster from Yale University, the average lifespan of a company in the S&P 500 has decreased from 67 years in the 1920s to just 15 years today.

He also estimated that 75% of S&P 500 companies will be replaced by new businesses by 2027!

Increased globalization and the widespread use of increasingly-affordable technology have accelerated the pace of change faced by businesses in virtually every industry.

Competitive advantages are proving more difficult to maintain as the world moves faster and faster, and our job as investors certainly isn’t any easy because of it.  [click to continue…]

Three Ways To Invest Better Using Statistics

When I was offered the opportunity to guest post on Andrew’s website, I was thrilled. I wanted to start by thanking him and my readers – I hope you enjoy this post.

Andrew and I share a very similar investment strategy. From his website, he is “an avid value investor who loves dividend paying stocks.” This describes me perfectly – in fact, I could have written it myself.

I am also a big believer in the importance of implementing statistics while investing. Too often, I hear of investors getting burned because they don’t perform their proper due diligence. It isn’t enough to pick the highest-performing stocks – you must also focus on risk.

Statistics, though considered to be boring by some, are a fantastic tool to reduce risk both at the security and portfolio levels. This post will present three ways to invest better using statistics.

Number One: Reduce Volatility Using Standard Deviations

Portfolio volatility is often used as a proxy for investment risk.

I’ve often had trouble grasping this, since the underlying value of a business does not typically change very much on a day-to-day basis. Stock prices, on the other hand, definitely demonstrate some extreme volatility on occasion. I really like this quote from The Big Short:

“[Burry] gave a talk in which he argued that the way they measured risk was completely idiotic. They measured risk by volatility: how much a stock or bond happened to have jumped around in the past few years. Real risk was not volatility; real risk was stupid investment decisions.

‘By and large,’ he later put it, ‘the wealthiest of the wealthy and their representatives have accepted that most managers are average, and the better ones are able to achieve average returns while exhibiting below-average volatility. By this logic a dollar selling for fifty cents on day, sixty cents the next day, and forty cents the next somehow becomes worth less than a dollar selling for fifty cents all three days. I would argue that the ability to buy at forty cents present opportunity, not risk, and that the dollar is still worth a dollar.'”

One thing that cannot be argued is that volatility is a proxy for withdrawal risk – which is the risk that you are forced to sell an investment when it is trading cheaply. While having a long time horizon is important, sometimes exogeneous forces mean investors are muscled into selling their stocks at undesirable prices (think car repairs, an unexpected medical bill, etc.)

As investors, we are able to minimize this risk by investing in stocks that have low historical volatility. A typical example is Johnson & Johnson, a healthcare conglomerate with a fantastic record of raising dividend payments over time.

Take a look at their performance and volatility in recent years:

Invest Better by Calculating Standard Deviation

With higher returns and lower volatility than it’s benchmark, Johnson & Johnson has delivered fantastic returns on a risk-adjusted basis.

This trend is also evident in the wider stock market. The S&P Low Volatility index outperformed the S&P500 by 2.00% for the 20 years ending in 2011. That type of outperformance, compounded over time, makes a huge difference in investment returns.

Bottom line: Don’t underestimate the effect that volatility could have on your portfolio. Low and slow just might win the race!  [click to continue…]

Quotes from 11 Billionaire Investors about Debt and Finance

There’s no better place to look for financial advice than from the winners of the game. While leverage (debt) can be perceived as a useful tool, you may be surprised at what billionaires think about it.

billionaire quotes debt

The advice may seem so uncommon and yet their results are so uncommon. Is it good fortune that created this mindset, or did this mindset create good fortune?

Read the following quotes from these billionaire investors and decide for yourself.

Charles Schwab (Net Worth: $6B)
“If there’s not enough money in the bank account, you don’t spend it.”

“When I was 14, I did all kinds of different odd jobs. I had a chicken farm, had an ice cream operation in the summertime, worked as a caddy; all things to make money and save money. Save money in order to invest – that was the first step”

Ken Griffin (Net Worth: $7B)
“All financial institutions live and die by their liquidity. We are a financial institution. The fact that many people don’t think about it is beyond me. It is the essence of what we do.”

Mark Cuban (Net Worth: $3B)
“Pay off your debt first. Freedom from debt is worth more than any amount you can earn.”

“If you’ve got $25,000, $50,000, $100,000, you’re better off paying off any debt you have because that’s a guaranteed return”

Andrew Beal (Net Worth: $8B)
“I’m not that much of a risk taker. I just take situations that people perceive to be high risk, and I decide that they can be managed to low risk.”

[click to continue…]

Is The Graham Number Still Relevant Today?

This guest contribution is from Ben Reynolds at Sure Dividend.  Sure Dividend uses The 8 Rules of Dividend Investing to systematically identify high quality dividend growth stocks.

Benjamin Graham is known as the ‘Dean of Wall Street’.  He is the father of value investing and mentor to Warren Buffett.

Graham did more than mentor and think about investing philosophy.  He was a phenomenal investor in his own right.  Graham’s investment partnership average returns of around 20% a year – for 20 years.  20% returns over 20 years turns $1 into over $38.  Graham’s investment methods worked amazingly well… From 1936 to 1956 when he operated his partnership.

Do Graham’s methods still work well today?

Graham had several different quantitative screening methods to determine which stocks are trading at attractive valuations.

This article applies ‘the Graham Number’ (one of his formulas) to the S&P 500.

The Graham Number

The Graham Number is used to quickly determine if a business is trading at or below fair value.  The Graham Number formula is shown below:

graham number

The Graham Number assumes that a fair price-to-earnings ratio is 15 and a fair price-to-book ratio is 1.5.  Interestingly, the historical average price-to-earnings ratio for the S&P 500 is 15.6.  Graham was eerily close to the ‘fair value’ of stocks with his formula – which he made over 60 years ago.

If the Graham number is more than the current share price, the stock is undervalued.  If the Graham number is less than the current share price, the company is overvalued.

The Graham number quickly weeds out overpriced businesses.  You won’t invest in the Facebooks (FB), Googles (GOOG), or Amazons (AMZN) of the investing world by using the Graham number.

The S&P 500 is currently trading for a price-to-earnings multiple of around 25.  As a result, fewer businesses will ‘pass’ the Graham Number now versus when stock prices are depressed – say during Great Recession lows in March of 2009.

The Graham Number Meets the S&P 500

Applying the Graham Number to the S&P 500 yields interesting results.

Only 58 businesses pass the Graham Number valuation screen.  You can download a valuation spreadsheet of all S&P 500 stocks valued using the Graham Number here.

Only 11.6% of S&P 500 stocks pass the Graham Number screen.  This is because the market is currently trading far above its historical average price-to-earnings ratio.

Of the 58 stocks that do pass the Graham test, 34 are in the financial sector.  This is because financial sector stocks tend to have lower price-to-book ratios.

Graham’s Greatest Student

To what extent is Warren Buffett influenced by Benjamin Graham?  [click to continue…]

Common Financial Characteristics of Top Dividend Stocks

Financial data can help us paint a picture of the story of a company. In order to know that a company succeeded during a certain time period, we don’t have to be plugged into that industry or even be alive to know that the company did well. All it takes is a cursory look at the financials released at that time.

top dividend stocks

Because our research is focused on companies in the stock market, the information we seek is freely available online. For official annual reports, sec.gov archives those all the way back until around 1994~1995. For widely used numbers such as net earnings, Wolfram Alpha allows us to search that data back to about 1982~1987.

The bottom line is that we can use tools free available on the web today to study a company’s financials and determine when a company did well. My free investing for beginners guide shows you how to do exactly that.

However, it’s one thing to look back at the past and see it for what it is. The numbers paint the picture and we can take the time to read it, but that doesn’t make it useful.

In fact, randomly picking successful stock winners and looking at their past can lead us into survivorship bias, where our data becomes skewed because we are ignoring the stocks that didn’t do well and only focusing on stocks that did do well.

But we can take a group of stock winners and use their data to see if any common characteristics arise. I did this when researching the biggest bankruptcies of the 21st century, and found that negative net earnings was the most common characteristic of a stock about to go bankrupt.

Top Dividend Stocks Research

Today I want to examine the other side of the spectrum, stocks that perform exceptionally well. For this list, I wanted to study stocks that had returned over 12% a year for a long period of time and also paid a dividend.

I found an article written by Sure Dividend that comprises of this exactly. The dividend stocks from this list are all now in the S&P 500 and were among the best on a return earned to shareholders basis over the past 25 years.

In fact, every one of these 15 top dividend stocks returned an average of 16% or more over this 25 year time period.  [click to continue…]

Stock Market Days Up vs. Down Percentage

So I was doing some research on the S&P 500 and came across some interesting data. Basically, I wanted to know what the stock market does on average. I particularly wanted to know the percentage of how many days the stock market is up vs down.

Getting my data was actually simpler than you might think. I went straight to Yahoo Finance and entered S&P 500 as a search for a ticker. From there I selected the “Historical Data” tab and then selected a time period of 20 years: from January 1, 1996 – January 1, 2016.

Unfortunately that data didn’t have the % return for each day, but it wasn’t much trouble to find that out. I exported the 20 years of data into an Excel Spreadsheet. With this option, I was able to make quick judgements and conclusions with a little manipulating.

stock market days

In the Excel Spreadsheet, I created a quick formula in a new column. To make this easier to type and understand, assume x = adjusted close and y = adjusted close the previous day. So my formula was =(x – y) / y. This gave the return % for the day. I simply dragged this formula down the entire column so I had return % data for 20 years.

This is great, but who has time to count each number and tally up the positive and negative dates? I certainly didn’t, so I found this out in a quick and clever shortcut.

I made a new formula in the column next to return %. Assume Hx refers to the cell(s) in the return % column. It was =IF(Hx > 0, 1, 0). Basically this means that if the return % is positive, put a 1 in the cell of the new column. If the return % is negative, put a 0.

Dragging this down the column (which you can do by clicking the bottom right hand corner of the cell and holding it down and moving the mouse down), I had 1s and 0s for every day of the 20 years. Now all I had to do was select every cell in that column, and look at the “Sum” at the bottom of excel. This gave the number 2683.

Next I needed the total number of days. Remember that the stock market is closed on the weekends and holidays, so it wasn’t as easy as 365 * 20. So I made a new column with the first cell having a value of “1”, and dragged it all the way down. The “Sum” of that was 5035. [click to continue…]

It’s no secret. The performance of companies can be measured by numbers. Some numbers are more helpful than others in determining this. Tools like the Value Trap Indicator and Altman Z Score formula are geared toward doing just that.

z score formula

Both tools are extremely efficient in avoiding companies that are about to go bankrupt. One of my readers is a stock analyst and interested in the differences between the two. Here’s his question and my answer.

Hello Andrew,

I am an analyst and investor based in India. I came across your VTI book and website (yet to purchase the book).

While the idea of identifying value traps and differentiating them from value buys is great, what I need to know is whether the VT indicator is a number similar to the Altman Z-score. Indeed, how does your VTI differ from Z-score since the objective is somewhat similar, if not the same.

With warm regards,
Nitiin

The Value Trap Indicator is indeed a number similar to the Altman Z-score. Both aim to warn against a company that is about to go bankrupt. However, there are a few other features of the Value Trap Indicator that the Z score formula doesn’t have that proves to be very useful to the investor.

Let’s examine the Altman Z Score formula first. The Altman Z-score uses 5 business ratios to predict bankruptcy. The NYU Stern Finance Professor Edward Altman created the Z score formula out of a data sample of 66 manufacturing firms. Half of those firms had gone bankrupt, while the other half scored well on the formula.

Altman’s Z Score formula was later tested and proved to be about 72% accurate in predicting bankruptcy within 2 years. From about 1968 to 1999, the Z score was tested to be somewhere around 80 – 90% accurate in predicting bankruptcy.

The Altman Z Score formula itself is quite easy to calculate. It is:

Z = 1.2 * (Working Capital / Total Assets) + 1.4 * (Retained Earnings / Total Assets) + 3.3 * (Earnings before Interest and Tax / Total Assets) + 0.6 * (Market Value of Equity / Total Liabilities) + 1.0 * (Sales / Total Assets)

All of these ratios can be calculated from the financial data in a company’s 10-k annual report filed to the SEC. Using actual terms from the 10-k, the z score formula looks like this:

Z = 1.2 * [(Current Assets – Current Liabilities) / Total Assets] + 1.4 * (Retained Earnings / Total Assets) + 3.3 * [(Net Earnings – Net Earnings from Discontinued Operations + Income Taxes on Continuing Operations + Interest Expense) / Total Assets)] + 0.6 * (Market Capitalization / Total Liabilities) + 1.0 * (Revenue / Total Assets)

…Where Retained Earnings can be found in the balance sheet under the “liabilities and shareholder’s equity” section.

Within this calculation, a z score of 3.0 or higher means a company is relatively safe from bankruptcy, while a z score of 1.8 or lower means a company is in great danger for bankruptcy.

Compare this to the Value Trap Indicator, which uses a combination of 7 categories of financial ratios. A company with a VTI greater than 800 is in great danger of being a value trap and losing much of its share price or heading to bankruptcy. A company with a VTI less than 250 is considered a potential great purchase.

Similar to the z score, the Value Trap Indicator was tested on the 30 biggest companies that went bankrupt from 2001 – 2012. From that data set, the VTI was successful in avoiding 29 of the 30, for a 96% success rate. In other words, only 1 company of the 30 scored a VTI less than 250. Of the 30, 22 had a VTI greater than 800.

Both the Z score formula and the VTI formula are clearly great tools for investors wanting to avoid stocks headed towards bankruptcy.

However, there is a subtle difference in the two formulas. [click to continue…]

A few weeks ago, I discussed why you shouldn’t rely on qualitative analysis for your stock market decisions. On the other side of the coin is the option of quantitative analysis. I’ll explain the philosophy behind it and provide the reasoning behind my support of it.

A quick Google search of quantitative analysis returns the definition as “analysis of a situation or event, especially a financial market, by means of complex mathematical and statistical modeling”.

quantitative analysis

Investopedia extends this definition as “measurement, performance evaluation or valuation of a financial instrument.”

It is the analysis of a financial instrument, not a situation or event that we are most concerned with. A financial instrument is simply an asset that can be traded like a stock or bond.

So what’s the point of being able to find the valuation of a stock? Will quantitative analysis really assist in finding stocks that will increase in value on average more than they decrease?

To answer that question, we must look at the basics behind a security (or stock).

A stock simply represents part equity in a business. Equity means an ownership stake. So, to understand the basics of a stock, we must understand the basics of the business behind it.

The primary goal of a business is to turn a profit. All of the complicated moving parts surrounding the business world and the corporations inside eventually circle back to this chief point.

There are many strategies behind doing this, and some companies delay turning a profit in the present to expand the business quickly, but the final end goal resides with turning a healthy profit.

Other elements of the business, such as assets on the balance sheet (property, buildings, equipment, etc.), are acquired to assist in creating revenue.. Which turns into profit.

I hope you can understand my point. There’s plenty of complicated jargon, industry specific metrics, and accounting details that could possibly involve quantitative analysis. But it always comes back to the most important question, if the company is making a profit. [click to continue…]

Since I run a site geared towards beginners, I hear a lot of the same questions. One of the most common frustrations I get from readers is that they don’t have enough money to invest.

Whether you’d like to believe it or not, this is a powerful obstacle in the way of many of us wanting to make money from the stock market.

money to invest

It’s a catch-22. You can’t invest without money, and a great way to make money is through investing. Now I wish there was some magical way I could snap my fingers and fix your problem.

But there’s not one. Barring fortunate financial circumstances, money must be earned in the same way that it’s always been earned: through the sweat of the brow called hard work.

Fortunately, there’s smarter ways to go about this. Money doesn’t have to be this elusive treasure that everyone except you has access to. People have been successful before you, are successful right now, and many are willing to share why. There’s all kinds of resources like this.

And sometimes the right resources are all you need to kick start your money machine. I’m hoping at least one that I share will be of value to you. If you can combine your intellect with your ambition to work hard, maybe you can come up with some ideas on your own.

For the rest of you, you’re probably lost. I KNOW many of you are.

So here’s 10 proven ideas for getting more money to invest.  [click to continue…]

Why NOT to Use Qualitative Analysis

The theories behind how to analyze a stock can vary greatly depending on who you are talking to. There’s guys who like to focus on the growth of a stock, and those who focus on finding value. There’s those who like to examine the business, and those who like to look at the chart.

In this same regard, there are investors who focus on the qualitative features of a business, and those who focus on the quantitative. Now of course there are upsides and downsides to each one. Let’s talk about qualitative analysis and form an opinion on the matter.

qualitative analysis

Google’s dictionary defines the word qualitative as “measuring the quality of something rather than its quantity”. The term qualitative analysis is defined by Investopedia as security analysis that uses subjective judgment based on unquantifiable information.

The characteristics that investors who rely on qualitative analysis usually focus on usually revolve around the perception of management, the perception of the market or industry, the perception of a company’s future prospects due to perceived demand or strong R&D, or other such intangibles.

Examining this further, the top comment on businessdictionary.com defined solid qualitiative analysis as when “you can just tell it has good value to your company”. As you dig more and more into the central thesis of qualitative analysis, you’ll see it centers on the investor’s emotions about a company.

If you’ve been following my blog for any amount of time, you’ll know I argue profusely against letting your emotions dictate your investment decisions. We know the stock market runs off of the collective emotions of all investors involved, constantly varying in degrees of fear or greed.

Many investors’ shortcomings come from being swept up in these emotions.  [click to continue…]