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:
- 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.
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.
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:
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%.
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.
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.
In Croatia, stocks are still 75% below their 2007 peak.
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.
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.
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.
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.
On top of everything, the company has been paying a dividend for more than 89 years and dividend payments are constantly increased.
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.
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.
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.