Many people make the mistake of investing in a stock simply with the hope or belief that it will or might go up in value. However, there is a very popular mantra that states “Hope is not a strategy.” Some attribute the origin of this mantra to former New York City Mayor Rudy Giuliani during his speech at the Republican National Convention on September 3, 2008 where he said “because change is not a destination, just as Hope is not a strategy.” Others credit a well-publicized letter sent to Barack Obama by economist, and Dean of the Business School at Webster University in St. Louis, Dr. Benjamin Ola Akande that was titled “Hope is not a strategy.”
Regardless of its origin, the phrase “Hope Is Not a Strategy” is profoundly applicable to common stock investing, and all investing for that matter. Prudent investing should always be implemented based on a well thought-out plan and strategy for success. As the admired baseball legend Yogi Berra so aptly put it “if you don’t know where you’re going, you might wind up someplace else.” Or perhaps better yet, Yogi also said “you’ve got to be very careful if you don’t know where you are going, because you might not get there.”
I contend that successful investing implies knowing where you are at least attempting to go. In other words, every investor should have a realistic, clear, measurable and accountable return objective in mind before they make an investment. Russian economist Dr. Vladimir Kvint provided one of my favorite definitions of a strategy as “a system of finding, formulating, and developing a doctrine that will ensure long-term success if followed faithfully.”
Invest With a Clear Return Objective
[drizzle]In my most recent article found here a loyal reader of my work offered this suggestion in the comment thread:
“However IMO, your first 5 paragraphs are succinctly instructive to diversified equity portfolio construction, and worthy of every reader’s thoughtful consideration. It would be worthy of your consideration to repeat that content in a future article.”
Not only was I flattered, I also agreed with his suggestion which was the inspiration for this article. Therefore, I’ve repeated those five paragraphs in this article and offer them as the foundation for this more comprehensive overview about investing in stocks with a clear and precise return objective in mind.
Prior to making an investment in any stock, I always proceed with a clear investment objective in mind. However, my objectives are not necessarily the same every time I invest in a stock. There are times when my objective is current income, and in contrast, there are other times when my objective might be maximum total return. At other times, I may be seeking a combination of both income and growth. My investment objective is determined by what my needs are at the time.
Additionally, I do not engage in vague or generalized objectives such as trying to beat the market. Instead, I endeavor to have an exact and realistic objective and precisely estimated return calculation that is commensurate with the type of common stock I may be examining. For example, if I was looking for maximum current yield and reasonable safety in order to provide a specific level of current spendable income, that is where my focus and analysis would be. With this need for a current income objective, I might turn to researching high-yield, low-growth utility stocks.
However, and this is the crux of my position, I would not invest in a utility stock thinking that I will outperform the market in either capital appreciation or total return. Utilities tend to be slow growers, and as such, do not usually produce high capital appreciation. On the other hand, when I invest in a utility stock, I fully expect to receive significantly more income than the market would provide. Consequently, I would measure the success or failure of this investment based solely on the dividend income I expect to receive.
In contrast, if I was looking for high total return, my focus would primarily be on the earnings growth potential of the stock I was considering. If I was desirous of generating a high total return capable of beating the market, I would look for a company that I was confident would generate a higher earnings growth rate than the market. And most importantly, in either case, whether I was investing for current income or total return, fair and sound current valuation would have to be evident. Fair valuation is the universal principle that prudent investors are wise to consider regardless of the type of investment or return objective that is desired.
Once my general investment objective is clearly defined and established, my focus then turns toward a specific and precise return calculation. In other words, I never invest in a stock merely hoping that it might go up. Instead, I always have a specific return number and objective that I expect my investment in a specific stock can provide. Moreover, my precise return expectations are always based on rational assumptions, which I input into standard rate of return calculation formulas. These rates of return assumptions, based on rational inputs, become my benchmark that I closely and continuously monitor and evaluate.
Fairly Valued Opportunities
Consistent with the theme of this article that hope is not a strategy, is also the idea that it’s not enough just to identify a great company to invest in. To truly receive results that are commensurate with the risks associated with investing in a stock, the prudent investor must also be disciplined about the valuation they pay when investing.
As I have stated many times, you can overpay for even the best company. Consequently, I am a believer that assessing fair or sound valuation is one of the most important considerations that prudent investors should make. As I will soon illustrate, fair valuation will be one of the most critical elements when attempting to calculate future potential returns available from investing in a company.
This concept should become self evident as I provide the following examples in order to illustrate how I go about determining the return potential that investing in a given company might offer me. Therefore, I will start with providing examples of companies that I consider fairly valued currently, and then elaborate on my process of calculating future return potentials. For perspective, I will follow these examples with one example of an overvalued company. Assessing the future return potential of a company that you already own, that has subsequently become overvalued is an integral part of a prudent strategy.
Current Income Conservative
Johnson & Johnson
The following earnings and dividends only F.A.S.T. Graphs™ on Johnson & Johnson (JNJ) represents a quintessential example of the type of conservative income stocks that I personally covet. This is truly a great company that has produced amazingly consistent earnings and dividend growth over many years running. As a conservative retired investor or dividend growth investor, you couldn’t find a higher quality company to invest in then AAA rated Johnson & Johnson.
Unfortunately, as the following graph on Johnson & Johnson with monthly closing stock prices added (the black line) illustrates, it has historically been very rare to find this