Let’s face it, stocks are an excellent way to build wealth and produce income. But building wealth comes in many different ways: living within your means, lower expenses, raising income levels, minimizing debt, and investing money in a way to produces wealth.
Remember, money (wealth) is just a tool and it’s up to you to determine how to use that tool. If that means retiring early, giving more to charity, or allowing your spouse to not work anymore is all your choice.
And that is the point. Financial Freedom comes because you built the wealth and what happens next with that freedom is up to you. It’s also up to you to figure out how to gain wealth to achieve that freedom.
Regular readers of this blog know that I write on a variety of personal finance topics. But many of you are here to read my take on stocks. I don’t write on important details like quarterly earnings, payout ratios, or debt repayments of individual companies – you can visit other sites for that (i.e. Seeking Alpha). You’ll never see me breakdown Coca-Cola or Exxon’s quarterly earnings — it just won’t happen.
Instead, you’ll learn more about my approach and philosophy on stocks more than anything. Sure, I read the details but I don’t like to write about them. My articles will be more about how to use individual stocks to build wealth instead of arguing about the short-term movements of each. I’ll provide high-level concepts from various masters that I’ve adopted for my own use.
Speaking Of The Masters …
When I originally started writing this article, I laid out the high-level components I felt were important to build wealth through individual stocks. When looking for a quote or two to emphasize certain areas, it dawned on me that Warrant Buffett has spoken to all these topics.
So, I decided to bring my opinions together with Mr. Buffett’s (the real expert) quotes and see how he feels on the topic. And let’s not forget what he said in his annual report to shareholders this year. He suggested an S&P 500 Index fund is the best way for most people to invest in the stock market. How can I argue with that?
But this article assumes you know that and still decide to buy individual stocks. Here we’ll identify some important components that have led me to start building my Master Stock List.
These are meant to be high-level concepts and are not in order of importance. Each concept can be explored in more detail either on this site and in many other places on the internet.
Don’t Pay Too Much
If you are buying lower growth, lower beta, dividend paying stocks then price matters. For those that bought Coca-Cola in 1999, when it had as PE of 50, were doomed to lower returns for several years. If you bought that same stock in the mid-1990’s or after 2003 then you were right on target to building significant wealth.
Same stock (Coca-Cola), but when (and at what price) you purchase it makes all the difference in building wealth. I love Exxon and Colgate-Palmolive too but always at the right price. You’ll never see me pay 25-30 times earnings for Colgate-Palmolive when it’s a better value under 20 times earnings.
“The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table.”
Warren Buffett
For example, AT&T was recently in the doghouse because they purchased Time Warner and took on a lot of debt. There were concerns with AT&T’s ability to maintain it’s healthy dividend, managements ability to create value, and aggressively pay down it’s debt. To Mr. Buffet’s point, the price of AT&T dropped to $27 with a 7%+ dividend yield … the market put it on the operating table. Within a year, it’s rebounded to $39 for a nearly 50% return.
Buy and Hold
This isn’t a “rule” of investing but it should be. It basically means you should buy something that you feel you’ll hold onto forever. If you are buying quality businesses at a good price, why wouldn’t you want to hold it forever?
“My favorite holding period is forever.”
Warren Buffett
This is as simple as saying buy and hold and then buy more when the price of the stock dips in price. I made this same argument in Go Long To Build Wealth recently. Thinking long-term is actually freedom from headline news, recessions, and TV talking heads. Achieving this mindset provides you with a calm while others are panicking.
The same concept can be said for marriage. Why get married if you can’t imagine holding onto that one person for the rest of your life? If you find quality (spouse or company) then never let it go.
Best In Breed
What is a “best in breed” company? They are industry leaders – think Exxon, Chevron, Royal Dutch Shell – and they have growing earnings and excellent balance sheets. They can still have some debt but they have strong cash positions and cash flow.
“Only when the tide goes out do you discover who is swimming naked.”
Warren Buffett
To me, Buffett’s quote means when the economic crap hits the fan it’s the quality companies that will still be swimming with their clothes on. Exxon, Johnson & Johnson, and Coca-Cola are built to last and it’s when times are bad that you really appreciate owning quality.
Most times, these are companies that have proven ability to adapt to change – technology, political, social – over multiple decades and generations. They’ve created a culture of disruption and innovation that most others can’t match. That’s why they are best in breed and that’s why you need them in your portfolio for the long-term.
Familiarity (Strong Brands)
In Peter Lynch’s book “Beating the Street,” he often talks about roaming the mall, watching people, and buying things you are already familiar with. He suggests asking your kids about their interests or what’s hot at school.
His point is spot on. Keep your eyes open and be aware. I remember in my travels I kept hearing about Square (SQ). I’d pay my taxi driver and my yogurt store with this application. It was everywhere and I should have taken advantage of that knowledge and purchased Square at $10 per share before it raced to $100.
“Only invest in ‘simple businesses’ that you understand.”
Warren Buffett
And other than starting with my Master Stock List, a great place to look for potential companies to buy are brand rankings. According to Forbes 2019 rankings, here’s this years strongest brands:
- Apple (on my list)
- Google (on my list)
- Microsoft (on my list)
- Amazon
- Coca-Cola (on my list)
- Samsung
- Disney (on my list)
- Toyota
- McDonald’s (on my list)
- AT&T (on my list)
- Louis Vuitton
- Intel
- Nike
- Cisco (on my list)
It should be no surprise that eight of the top fifteen brands are on my Master Stock List. My list is always evolving and Nike could still eventually make it to the list too. The point is, we understand most of the businesses on this list.
Being on this list doesn’t necessarily make them investment quality stocks. But if you add in some of the other components in this article then you have the makings of a potential stock to add to your portfolio. But that’s only assuming you can buy it at the right price.
Diversification
Well, this is an interesting topic. Nearly all books, classes, or guru’s say you should be well diversified. And this is were Warren Buffett strays from the pack some. In a 1996 Berkshire Hathaway shareholder meeting, he answered someone’s question about diversification.
“Diversification is protection against ignorance.”
Warren Buffett
Buffett was saying that if you don’t have expertise to dig into the financials then owning 30-50 or more stocks is fine for you. He believes their aren’t 30 or 50 Coca-Cola’s in the market that are worthy of your investment money. So, why put your money in sub-par investments? He focuses on putting 40%-50% into 5-7 companies and the remaining into another 10-15 stocks.
I get his point. But for the average Joe or Josephine, 30-50 stocks will be just fine. Personally, I’ll probably own around 30 stocks with a “slightly” higher emphasis or weighting on a core 10 stocks.
Owning most of the sectors (Energy, Consumer Goods, etc…) is a good idea but you need to be careful with some of them. For example, banks and technology stocks have a much higher beta than other sectors. Bank of America has a beta over 1.6 and we saw what happened to banks during the financial crisis.
Same goes for technology too. During bad times, these stocks can go down 50%-75% during economic hard times. And that’s not what I’m looking for in my retirement portfolio. The last thing I need in retirement is a big chunk of my stock portfolio to lose 75%. Low beta is just fine for me.
Preserve Capital
Your blood, sweat, and tears have created a surplus of money to invest – well done! All the meetings, work travel, teaching, cavities filled or whatever work you do allowed you to invest. This is your hard earned money so it’s wise to not gamble it away.
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No.1”
Warren Buffett
This surplus of money needs to be protected from loss while still taking on some risk. This money needs to produce income so you can achieve financial freedom. Unfortunately, this is a rule I’ve broken many times in my life (Part 1 and Part 2) and it’s one of the few regrets I have.
Not preserving your capital only guarantee’s that you’ll be working longer. Losing your capital is the opposite of building wealth. It’s very simple – never lose money and you’ll have a chance of building wealth and gaining your financial freedom.
Receive Dividends
A company can do four things with their profits: (1) reinvest in the company, (2) acquire other companies, (3) repurchase shares, and (4) pay shareholders a dividend. Personally, I like a company that does all four but receiving dividends is important so that you can reduce your dependency on work income.
No quote, just fact. As of this writing, Warren Buffett’s top 14 holdings pay dividends!
WarrenBuffettStockPortfolio.com shows his holdings
I love dividend stocks, especially if the company has a track record of reliable, sustainable, and growing dividends. It’s pretty clear that Warren Buffett does too. Dividends are an investors best friend isn’t just a saying, it’s another article too. This sounds like a good time to drop the microphone.
Summary
Getting your portfolio to the $100,000 mark as early as possible in life is significant. At that point, dividend compounding will do things for you that are simply beautiful. Even if your stock is running flat for several years, a reinvested compounding dividend is building wealth and giving you time to build a position. Personally, I consider a flat stock price a gift knowing that eventually the market will pay you for your patience.
And please, protect your money from loss. It’s so hard to rebuild lost capital and it delays your financial freedom. One way to do that is to buy quality companies with growing dividends. Depending on the company, you might receive your entire capital back in dividends in 10-15 years regardless of what the stock price does.
I’m not saying you’ll never sell a stock but that should be a rare event. Get comfortable with the thought or mindset of holding a company regardless of headlines. Consider a drop in price of a quality company a gift and an opportunity to buy more. Dollar cost averaging with quality dividend companies is much different than averaging down on junk.
I can’t explain the calm I feel knowing that headlines and TV talking heads mean nothing to my investing day. I can only hope you reach this zen mindset because your quality of life will improve too.
Thanks for reading!
Mr. TLR