Thursday, March 5, 2015

Keep It Simple

When I look at investing in a company, I think of the KISS principle.
A design/engineering principle noted by the US Navy in 1960, it’s an acronym that originally stood for: Keep it simple, stupid. You can use another variation of it that is perhaps less offensive, like keep it simple and straightforward. But the point remains that, in investing, simple is oftentimes better.
And simplicity, or a greater degree of it, is what I love so much about dividend growth investing. You’re basically boiling down the thousands of publicly traded stocks into a much more manageable list of a few hundred. Even better, that process screens out most of the junk, because you simply can’t increase dividends for decades on end without generating profit/cash flow growth in kind.
So I don’t need to worry about whether or not a startup out of California is going to design the next app or sensor that’s going to take off. And I needn’t concern myself with if/when 3D printing will become a much larger industry and/or which companies will dominate (and which will fail). I just need to make sure I feel comfortable with the odds that people will continue buying, say, toothpaste for the next few decades.

What’s The Story?

Before I even look at a company’s financial metrics or other fundamentals, I like to ask myself what a company is all about.
What’s their story? What do they do? How do they do it? Is it something I can easily understand?
Even better, I like to make sure I can condense a company’s story down into one or two short sentences.
I’ll give you a few examples.
The Coca-Cola Co. (KO): Manufactures and markets a variety of sparking and still beverages across the world.
Easy, right? We can all understand humanity’s need to drink fluids of some sort. And one can look at Coke’s broad portfolio of beverages and see something for everyone – orange juice, soft drinks, water, tea, coffee, etc. That kind of business model is extremely simple to understand at its core. There’s certainly a bit more to it than that, but being able to discern what a company does in a easy-to-understand sentence or two is really at the heart of my strategy.
Johnson & Johnson (JNJ): Provides a number of healthcare products to clients ranging from the general public to healthcare professionals.
Sure, I could write a book on the company, its history, products, and future potential. But it boils down to something that’s pretty simple. I can understand Tylenol, Benadryl, baby shampoo, joint replacements, and pharmaceuticals. This is a company with a market cap north of $280 billion, but it’s not that difficult to understand the core operations, the products, how they make money, or how they will likely continue to make money.
Realty Income Corp. (O): Purchases commercial real estate, rents it to high-quality tenants, and uses that rent to mainly pay shareholders a healthy dividend.
That’s pretty much it. I get that real estate is a bit more complicated than that, which is exactly why I let Realty Income and the management team handle the complicated stuff and send me a check. But it’s also an incredibly easy business model to understand. Furthermore, I don’t have the liquidity to go out and buy a bunch of commercial real estate, nor do I have the time, interest, or inclination. But I don’t have to. They handle it for me and send me my check. How easy is that?

Can It Be Explained To A Child?

Never invest in any idea you can’t illustrate with a crayon.
– Peter Lynch.
I love that quote. Even more so, I love the idea behind it.
But I take it one step further. I like to make sure that I can explain how a company works to a child. In fact, if a company were pitching me an investment, I’d ask them to talk to me like a child. Tell me what you do and pretend that I’m ten years old. That eliminates all the pretentiousness right away and gets right down to the nitty gritty.
Could I explain how Coca-Cola works to a ten year-old? Would they understand orange juice, Coca-Cola, and tea? Probably so.
Would I be able to tell a ten year-old how Walt Disney Co. (DIS) makes money? Could I show that child a DVD of Frozen? Could I take them to one of their parks? Could I flip on ESPN (if I had cable)? Absolutely.
So on and so forth.
There are many companies that I’ve avoided over the years because I couldn’t totally understand the business model. And if I can’t understand, how could I expect a ten year-old to?
Take a company like Annaly Capital Management (NLY). Could I easily explain to a child how mortgage pass-through certificates and collateralized mortgage obligations work? Not really, because even I’m not real sure how they work. Now, I’ve had many people tell me what a great company (and stock) NLY is over the years because it’s typically yielded well into the double digits. Keep in mind, however, that its dividend today is half of what it was just five years ago. And so is its stock price. Now, if you can easily understand CMOs and all the risks therein, go for it. But it’s not for me.
I’ve discussed before that it’s not necessary as an investor to understand every iota of a business. But if you can reasonably explain the basics to a child, you’re in good shape.

Conclusion

I’m going to be discussing this concept – keeping it simple – a bit more over the coming days because it’s a concept that I think deserves a greater discussion, and perhaps one that is too long for one article.
But this is a great introduction to the thought process of keeping investing simple. You don’t need to invest in a complicated manner to make money.
For instance, Coca-Cola has returned an annualized 10.10% over the last 10 years with dividends reinvested (compared to SPY’s 8.02%). And they’ve increased their dividend at an annualized rate of 9.33% over that time frame. That’s even factoring in the troubles they’ve had over the last few years with slowing volume growth across sparkling as well as currency headwinds. If 10.10% isn’t enough for you to realize your dreams then you’re simply not saving enough. Furthermore, Coca-Cola has given you less risk than the overall market with a beta of 0.47. Less risk and more money? I’ll take it.
Full Disclosure: Long KO, JNJ, O, and DIS.
What do you think? Do you keep it simple? Can you explain your investments to a child? 
Thanks for reading.

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