Over the past years, I’ve been making some macroeconomic videos, I like the mental exercise, analysing the long-term risks etc. However, I must say, all that ‘mumbo jumbo’; GDP, economy, debt, trade wars, employment, housing etc. hasn’t helped me at all when it comes to investing. I am subscribed to an economic newsletter from the Wall Street Journal and in the last 4 weeks there were two positive and two negative headlines all about the US housing market, so funny.
The fact is that companies are living beings that adapt to circumstances, grow and change over time. By looking at the business, not the economy is actually where I get my investing value. As I am really pushing on the research, more and more of it will be business specific and less macro. Although macro is fun to look at, discuss and you can talk about it for eternity, talking about it doesn’t really help your portfolio.
For example, the S&P 500 has been flat since January 2018.
The point is that nobody could have predicted where the S&P 500 could have gone, it could have been up 20% or down 30%. It is all a guess, no matter how much macro you study. The point is that we have to focus on the business, nothing else.
I’ll take this opportunity to discuss the real news and news that could be important for your portfolio.
Extremely important news 1: your long-term investment returns are driven by earnings
Earnings are the key, not economics
In 1999, S&P 500 earnings were 58.55 points. Today we are at 130 points. That is an increase of 122%.
How did the market do? Well, the S&P 500 was at 1282 points in 1999 and now it is at 2757 points, up 115%.
Earnings are up 122% and the market is up 115% over the last 20 years. In the mean time we have had the dot-com bubble crash, the great recession, a European crisis, Japan not growing anymore, a commodity boom and bust etc. Who knows what will we have in the next 20 years, but no matter what happens, good businesses will do well. Another thing that helps very much with determining stock market returns are valuations.
Keep an eye on valuations because the market is extremely differentiated
In 1999 the S&P 500 was at 1282 points with earnings of 58.55 that leads to a PE ratio of 22. Thus, the earnings yield is approximately 4.5%.
1282*1.045^20= 3091 points
According to the valuation, investors could have expected a return of 4.5% based on the valuation they were paying in 1999. The return was even a bit higher when you add the dividends of just below 2% per year.
There will definitely be market crashes in the future but you can’t time them. Let’s say there is a crash of 30% 6 years from now but in the meantime, the S&P 500 grows at 5% per year. This would say that from the current 2757, the S&P 500 would go to 3694 points. If then it crashes 30%, we would be down to 2585 but by waiting for the crash you would have missed on the dividends so you wouldn’t be ahead. However, as we spoke that earnings are key, you can invest for higher than 4.5% returns by investing in earnings and taking advantage of the volatility.
The market is extremely differentiated and volatile – learn about the business
Earnings and volatility
If I look at the top 10 positions of the S&P 500, the PE ratios vary extremely and I can tell you that returns will vary extremely over the next 20 years.
Therefore, it is extremely important to look at try to understand where could your investment be in the next 20 years. This doesn’t mean that if a company falls out the top 10 it will be a bad investment. However, you can avoid buying companies with too stretched price to sales ratios and extremely high earnings valuations where the actual business doesn’t justify.
The point is that when you follow a company for a few years you begin to understand it much better than the media does, you understand its natural cycles and how to invest around those.
This allows you to take advantage of volatility. It is pretty simple if you have a long term view.
How to take advantage of volatility
The easiest was to take advantage of volatility is to rebalance your positions in relation to the earnings yield those offer.
The only problem is that you have to move your focus away from the news and future expected earnings and simply focus on the real current business earnings. Just 6 months ago, Apple’s stock was above $232 only to fall down to $142 in January and now rebound to $173. Apple’s earnings didn’t change that much, so if you focus on the earnings yield you can buy more when the earnings yield is higher, PE lower, and less when the yield is lower, thus the PE ratio higher.
I didn’t buy Apple, but in the summer of 2018 I invested a bit in Brazil because I did find an interesting business there.
I didn’t sell yet, but the increase in price gives me a nice thing to think about and see how it fits my portfolio. The point is that it is all easy when you invest in businesses. Which leads me to the most important news of all:
Invest in the business, be an owner
Invest when you are happy with the business earnings
By focusing on the earnings and not on the news, investing becomes easy. What is your required investment return?
4.5% – buy the S&P 500 and forget about it
7% – buy good businesses when their PE ratios are around 14
10% – same but at PE ratio of 10, or higher ratios buy with some growth
15% – look at good businesses in distressed sectors, value investments and take advantage of the market’s short term focus. This implies a lot of work but it is possible to find such opportunities.
Forget about news, focus on the business reality, the long-term reality
Earnings are the drivers of your investment returns, be a business owner
Focusing on earnings will allow you to take advantage of the market’s irrationality, or better to say volatility
News, economy, stock market crash, recession, GDP, Trump – not adding value to your investing, so focus on the business and that is what we do here, so please SUBSCRIBE!