You can retire by investing in the stock market – just don’t invest like everybody else in index funds

  • It is possible to retire earlier using the stock market if you focus on investing in businesses. Investing is all about business earnings and value.
  • This paper will show how historically, you can do amazing things if you think before you invest, or at least avoid the stupid mistakes others usually make. When it comes to retirement, small current mistakes are extremely costly in the long term. 
  • I’ll give you an example of a simple stock that has been paying a dividend for 89 years and will likely outperform most indexes. I’ll also add 5 stock ideas. If you find 20 of such stocks, you practically need nothing more for your retirement.

Financial independence and retiring is the goal of many investors. This booklet will cover current and future potential investing opportunities and strategies that will help you achieve your financial goals in the long term. To achieve financial independence sooner, with more certainty, one has to invest in investments that offer less risk and, at the same time, higher returns than other investments – this is called value investing.  

Financial independence topics covered are:

  • Stock market and retiring – great tool but use it smartly!
  • The economy, inflation and your financial independence
  • Real estate – the best leverage, diversification and inflation protection option.
  • A fixed vs. a dynamic investment mindset – over decades, things change.
  • Diversification, yes, but not like and when your banker advises.

In this article: 

Contents

  • Stocks can make you financially independent – but mind the valuations, value, business strength and risks
  • The value investing truth – buy businesses with value
  • PE ratio and price to book value
  • Value investing – Margin of safety
  • Current value and strong earnings example plus 5 stocks to watch
  • How can you find such stocks?

Index funds might not be the vehicle to your financial independence

The predominant investment advice you hear is to invest your money in index funds, usually the S&P 500 (SPY). Invest on a monthly basis and simply forget about it. 

That is a good advice, unfortunately it is better suited for the 1980s or 1990s than now. Nobody can argue that stocks have been an amazing investment over the past 35 years. Those that invested $1,000 in the S&P 500 in 1982, have now $26,000 and the dividend is $480 per year. Not bad on a $1,000 investment. Those that invested $100k in 1982, have now a dividend of $48k per year and a capital of $2.6 million. I would call that a wonderful retirement scenario.

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Source: Macrotrends

The problem is that back then, really few dared to invest in stocks. Even investing legends, like Ray Dalio, didn’t invest in stocks in 1982. Actually, stocks looked that bad that Dalio was betting against stocks and practically lost it all. 

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Source: Business Insider

Fast forward 35 years, and you can practically hear everybody discussing how index funds or ETFs are the best way to invest. I agree those have been the best way over the last 35 years, but I argue the same will not be true over the next 35 years. You cannot expect to invest $100k in the S&P 500 today and up with millions in 30 years simply because stocks were cheap back then and now stocks are expensive. Nevertheless, the best way is to still invest in stocks, but as in 1982, the best way is usually not to copy what the herd does.

The value investing truth – buy businesses with value

Let me tell you the little truth Buffett and other value investors like Seth Klarman use, the simple mindset that pushed Buffett to crazily buy stocks during the 1982 period while others, like Dalio, were selling.

Warren Buffett and other value investors focus on business earnings and the price paid for those earnings. To quote Seth Klarman from his book Margin of Safety:

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The thing that makes investing simple is understanding the investing law where long term investment returns are perfectly correlated to the performance of the underlying business. This means that when investing, one should focus on investing in good businesses, not stocks. Stocks are extremely volatile; good businesses simply continue doing business no matter what. In a good year most make good money, in bad years a little bit less and that has been the case since humanity.

The investing core around what your focus should be is that business earnings will determine your long-term returns and those are what you should care about when planning retirement or financial independence. 

Another thing mentioned by Klarman is value, there is a difference when investing in agricultural real estate the produces a healthy yearly yield and in stocks that offer mining cobalt in an African country. With the latter anything can happen while with value, you know you buy value. To quote Buffett:

“Value is what you get, price is what you pay”

Retirement is too important to bet it on promises from companies like Tesla, Lyft, Uber etc. Those might succeed, but if those fail, so does your retirement. I wouldn’t consider such stocks an investing option.

PE ratio and price to book value

The two best approximate indicators of business earnings and value are the price to earnings (PE) ratio and the price to book ratio. The price to earnings ratio simply divides the price, i.e. what you have to pay, with the underlying earnings a business delivers. The result is your business earnings yield, your long-term investment yield.

The S&P 500 mentioned above, has a PE ratio of 22 that leads to an earnings yield of 4.5%.

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Source: Multpl

Approximately 4.5% is what long term investors can expect when investing in an index like the S&P 500. Perhaps even a bit higher as earnings will grow in the future alongside economic growth. I would say 4% to 6% is what you can expect. It is not bad, but there are some risks one has to consider when making a retirement strategy.

The first risk is the S&P 500 earnings yield of just 4.5%. If we look again at the above chart going back to 1871 based on professor Shiller’s data from Yale, the average historical yield was 7.36%, in line with what has been the average historical return from stocks. The problem is that if in 10 years, the required return from stocks is back to 8%, like it was in 1990 and for the most part of history since we have stock market data, investors would actually look at miserable returns over the coming 10 years. Miserable returns are something that doesn’t help with retirement and those are not uncommon when it comes to investing. We have to always expect that one can look at negative real returns over one or two decades.

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Source: Macrotrends

Of course, one would say there are always the dividends, but in 1929, 1966, 2000 and 2019, the dividend yield was 3.3%, 3%, 1.5% and is 1.8% respectively. Thus, if stocks go nowhere for the next 20 years, you can count only on a dividend yield of 1.8%. For me personally, this is a big risk that can be avoided by buying investments that offer a higher yield for the same risk or even lower risk. 

Also, you cannot tell people in The Netherlands or Croatia that stocks always go up. The Dutch AEX index is still 18% below its 2000 peak. Fortunately, it is higher than the 2002 and 2009 lows that represented 70% declines. 

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In Croatia, stocks are still 75% below their 2007 peak.

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Source: Trading Economics

How to know when to buy in order to catch the upside and avoid the huge downside shown above? Look at valuations (business earnings in relation to price) and book value. The Dutch and Croatian markets had crazy valuations in 2000 and 2007 while the PE ratios were low in 2009. Given the above, I wouldn’t bet most of my retirement on any index just because it might have worked for some in the past. It doesn’t mean it will work for me now. It might work, but it also might not given the current valuation compared to historical parameters, too much of a risk when it comes to retirement.

Starcapital has excellently summarized what you can expect when looking at business earnings. To even out cyclical influences they have used the 10-year average PE ratio, the so-called CAPE ratio (cyclically adjusted price earnings). As the current CAPE ratio of the S&P 500 is 30, investors cannot expect great subsequent real returns. The average return can be expected to be around 5%. This is again not bad, but could always be better.

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Source: Starcapital

Let me first discuss value and then give you an example of a lower risk investment with a higher business yield. 

Value investing – Margin of safety

The easiest way to measure value is by looking at the book value. This is just the easiest as value comes in many forms but it will give you a good indication of what are the risks within a business. The price to book value of the S&P 500 is 3.43. This means that when you buy the S&P 500, you pay 3.43 times more than what it cost to build and create the underlying assets of the S&P 500. 

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Source: Multpl

You might wonder why would people pay more for something that costs less to build or create? Well, it is based on the good will and belief that those assets will deliver higher earnings and therefore that it doesn’t really matter what the book value is. This might be true given the asset light business models many now have, but as value investors we prefer investments where there is both a good business yield and a margin of safety in the form of value. Why not take both when you can have it both? It just requires a bit more work and research to find such opportunities.

To conclude on book value, history shows the same as what the CAPE tells us. When the book value is high, returns will be low and vice versa.

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Source: Starcapital

To conclude on the value and business yield discussion, even Nobel prize winners like Eugene Fama, famous for developing the Efficient Market Hypothesis, agree that value and size are key for achieving higher investment returns. On the size topic, the smaller the company, the better it is because it hasn’t yet been recognized by the market and you might actually get it at a fair price. Thus, you know where to look now.

Current value and strong earnings example plus 5 stocks to watch

According to the above, by investing in something that has a lower PE ratio and a lower price to book ratio, your long-term returns should be higher. Archer Daniels Midland (NYSE: ADM) is such an example. ADM is one of the world’s largest food processing companies, it has a PE ratio of 13.3, implying a business yield of 7.5% and a price to book value of 1.29 that in combination with the food business gives you a margin of safety. The CAPE ratio is similar to the PE ratio.

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Source: Morningstar

On top of everything, the company has been paying a dividend for more than 89 years and dividend payments are constantly increased.

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Source: ADM

If you wish to hear more about ADM, you can check my video analysis.

Here are other 4 companies you might wish to watch and buy when their stock prices offer a good business yield:

  • Apple (NASDAQ: AAPL)
  • Archer Daniels Midland (NYSE: ADM) 
  • Berkshire Hathaway (NYSE: BRK.A, BRK.B)
  • Consolidated Edison (NYSE: ED)
  • The Walt Disney Company (NYSE: DIS)

I firmly believe that having a list of 20 stocks like the above 5, taking a simple look at them once every month and buying those that currently have the lowest long-term average price to earnings ratio is practically all you need when it comes to investing. You will beat the market while taking on less risk, thus reaching your financial independence sooner and safer.

I also firmly believe that a portfolio of companies like ADM will outperform the S&P 500 in the long term due to their underlying business earnings. Over 20 years, the difference is staggering. $1,000 compounded at 4.5% annually leads to an amount of $2,411 while $1,000 compounded at 7.5% annually leads to $4,247. I think these are the things that matter when it comes to financial independence and retirement, safety and yield.

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How can you find such stocks?

It actually isn’t that hard; you just have to be patient and invest when good value businesses trade at lower valuations. Use common sense, look at book values and margins of safety and then simply buy when such a stock offers a business yield that is above your required return. 

The markets are irrational and mostly short term oriented so that even big companies like Apple often trade at low PE ratios offering higher than average yields.

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Source: Morningstar

When it comes to retiring or financial independence, I firmly believe it is worth it to spend a bit more time, analyze investment opportunities using a common sense value investing perspective and then buy only when you are sure that you get value for the price you are paying, value that is going to lead you to your financial goals.

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Latest Canada Pension Fund Investing Strategy

This pension fund investing strategy is for a Canadian customer that asked for my help when it comes to her pension fund investing and the unfortunately limited options she has in her pension plan. This is the list of options she has in her pension fund:

figure 1 options

The options are really limited but you have to do what you can with what you have. In order to help with the extremely important pension investing strategy, I did some research, and the more I researched, the more pissed I became as I couldn’t believe what I found.

I became really mad, and this requires immediate government intervention in Canada – the pension fund investment environment has to be changed immediately.

So, call Justin, I hear he is he is a nice guy, so if he cares about his people he will intervene immediately and lower pension fund costs!

THE FEES CHARGED BY PENSION MUTUAL FUNDS ARE OUTRAGEOUS

LET’s take a look at the funds and start with the money fund.

sla deposit fund

The bulk of a mutual fund is invested in cash and the management fee is 1%. The management expense ratio is at 0.56% but strange that it is below the fee.

figure 3 sla management fee

If I look at the yields, those are now a bit higher than the fee but still, the management fee of 1% and the management expense ratio of 0.56% on a money fund is outrageous! This means that the fund manager takes on average 50% of your gains!

Let’s take a look at a Fidelity fund that should have lower costs – Fidelity True North Fund!

figure 5 fidelity true north

The true north fund is charging 2.25% to its northern customers while its major selling point in the US are the low fees in the range of 0.04%. I think I missed profession, I need to become a fund manager in Canada and just live of the fat fees!

LET’s see a mixed fund like the SLF 2030 target date portfolio.

figure 6 slf milestone

This fund that invests almost 80% of its money in fixed income, charges a fee that is 2.28% of the assets under management. With the low yield environment, the returns will probably be negative by 2030, better give you money to charity.

figure 7 sla milestone 2030

THESE MUTUAL PENSION FUND FEES ARE OUTRAGEOUS

If you don’t want to be a 70 year old waiter serving those rich money managers, it is time for Canadians to step up and do something, if not you will be working as a 70-year old bust boy or girl on Vancouver Island serving the fund managers and their kids that are living the rich life spending your pension!

Just an example!

THE AVERAGE EXPECTED RETURN ON STOCKS AND BONDS – a mix usually in pension funds will be 4%. If I invest $3,000 per year for 30 years the total investment is $90,000 and the final amount should be $174,000 without fees. With a 2% yearly fee deducted from my account, the final value is $123,000. This leads to a pension 30% lower than what it could be thanks to fees.

feed

So, 30% of your pension will go to fees! 30% of your hard earned money! If we would put an average fee of 0.2% that you can get nice funds in the US for, on the same returns, it leads to a capital of $169,000.

chart

That is just 3% of your pension. A difference of 30% on your pension is the difference between being miserable and sick and living the last quarter of your life with decency.

You, the voters in CANADA, solve this – your pension has to be 30% higher just from getting lower fees!

NOW, let’s dig into the PENSION INVESTMENT STRATEGY!

The first thing that comes to my mind is that I don’t want to pay such high fees. As those fees are fixed, whether they make money for you or not, you pay the fee, so the best way is to take just a little bit of advantage from such a situation, if we can call it an advantage.

CREATE ANOTHER PENSION FUND AND BALANCE

Here I go back to Benjamin Graham – a defensive investor, or even an aggressive investor should balance between bonds and stocks (I would say safety and growth) in relation to what are the risks of investing in stocks.

A look at the market’s PE ratio shows that stocks are historically expensive and that we can expect are extremely low returns.

pe ratio spx canada

Historically, at such high valuations 10-year returns have been close to zero, put a 2% yearly fee on that and you can expect your capital to be 20% smaller in 10 years.

figure 4 tbill yields

I don’t expect much from such stocks in general – that is why I would not pay such high fees – so I would keep the cash position of my portfolio in the pension fund as I have to invest in that due to employee benefits, tax benefits etc. When stocks become cheaper again, or have a higher returns that doesn’t make the fee so outrageous, I would buy more stocks.

In the meantime, I would still make another portfolio where I would invest for the long term with better potential risk rewards, taking a bit more risk by investing in various stocks. If stocks fall, I have the money in the pension fund to buy more of those on the cheap.

So, the first pension fund strategy idea is to create your own counter balance portfolio!

If you are a bit more aggressive and still want to invest – again balance things out in the pension fund – just remember that Buffett has about 40% of his stock market portfolio in cash and he pays no fees on his stock holdings.

CREATE YOUR OWN DIVERSIFIED PENSION FUND – invest in businesses, stocks, real estate

There is no other option than to invest on the side, see what you own and how that will lead to your financial goals. It is extremely important to do so. Be hedged, because if you invest in the Canadian index you are really exposed to banks, that depend on the real estate market that consequently depends on your economy. However, you job too depends on the economy, so you are really only long the country and thus badly diversified.

As, said, think out of the box to create a better financial future for you! In this environment you have to take responsibility for your financial life and retirement because others it seems care only about fees.

Contact Justin and make him change the rules for your betterment!