9 Long-Term Investing Tips by Ben Reynolds
Here’s a few facts that will dissuade you about investing in individual stocks:
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- You aren’t smarter than the army of ivy league professionals large investment firms employ.
- They have better information and better trade execution.
- And they work long hours to dissect the fair value of stocks.
And yet… Many investors do outperform ‘the market’. Some investors can beat mutual funds and investment advisors.
Billionaire founder of the Baupost Group hedge fund Seth Klarman tells us how:
“The single greatest edge an investor can have is a long-term orientation” – Seth Klarman
To generate returns in excess of average, you must have an edge. That edge isn’t going to come from being smarter or having better information.
But it can come from investing for the long-term.
Professional investors are (unfairly) judged based on quarterly performance. One down quarter, and money can start flowing out of their fund. This causes professional investors to chase quarterly performance – and adopt a short-sighted investing mindset.
You don’t have to play the quarterly game. You can compound your wealth with long-term investing. This article gives you 9 tips on how to do just that.
Long-Term Investing - Tip #1: Follow The Wisdom of Warren Buffett
Warren Buffett is the most successful investor alive today. He is the 3rd richest man in the world – and an avid long-term investor.
Many of Buffett’s largest holdings were purchased decades ago. He first purchased American Express (AXP) stock in 1965. He bought both Coca-Cola (KO) and Wells Fargo (WFC) in the late 1980’s.
Buffett’s genius is to:
- Buy great businesses
- At fair or better prices
- And let them compound your wealth
He’s made a tremendous amount of money by sitting back and letting his wealth compound.
“When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.” - Warren Buffett
Buffett had many opportunities to sell Coca-Cola, Wells Fargo, and American Express over the last few decades – but he didn’t.
He doesn’t sell great businesses that continue to compound his wealth. There’s no reason to. Buffett’s advice to practice long-term investing is to:
“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.” - Warren Buffett
Far too often, people trade stocks instead of invest in businesses. The distinction is important.
When you invest in a business, you are taking partial ownership. You aren’t trying to make a ‘quick buck’ by hoping the stock price bounces up.
Investing and trading are different – and will produce different results over long periods of time. It’s telling that there are no traders that have built the level of wealth Buffett has.
Tip #2: Don’t Pay Attention to Daily Stock Price Moves
Stock prices fluctuate constantly. The seemingly random movement of stock prices can make investing feel like a casino.
It is anything but.
The stock market is a place you can easily buy or sell fractional ownership claims of real world businesses. Nothing more, nothing less.
If you bought a house, I doubt you’d sell it a week later because the price changed 10%. And yet, we do this with stock purchases.
Paying attention to daily stock price fluctuations causes investors to over-react to minor events that have no impact on the long-term earnings prospects of a business.
It’s better to stop checking your stocks at all than to look at them every day. If you can focus on the underlying business instead of the daily stock price, you will be well on your way to becoming a long-term investor.
Tip #3: Leverage The Lindy Effect
The Lindy Effect isn’t talked about often in investing circles. The Lindy Effect states that the observed lifespan of non-perishable things like businesses, books, ideas, and so on is likely to be half of the total life.
Said another way, if a business has been around 50 years, it will likely be around another 50 years. The Lindy Effect says that things that have proven they have staying power are likely to be around longer than things that haven’t proven their staying power.
It’s common sense when you think about it. A book like Plato’s Republic is likely going to be available for purchase around 500 years from now. Today’s top fiction seller – likely not.
When you invest for the long run, you need to invest in businesses that are going to be around for the long run.
The hot biotech stock with a 2 year operating history has not shown it has the ability to last through myriad economic conditions. A stock like Coca-Cola has.
Tip 4: Where to Find Great Long-Term Businesses
Where do you find great long-term businesses to invest in? There are 2 places I recommend for quickly identifying potential long-term investments.
The first is the Dividend Aristocrats Index. Dividend Aristocrats are S&P 500 stocks with 25+ years of steady or rising dividends. There are currently only 50 Dividend Aristocrats. They are some of the strongest businesses around. They have proven their ability to thrive in a variety of market conditions.
You can see all 50 Dividend Aristocrats here.
The second place to look for long-term businesses in which to invest is the even more exclusive Dividend Kings list.
There are currently only 18 Dividend Kings. To be a Dividend King, a stock must have 50+ years of consecutive dividend increases. These are truly the longest lived businesses around. You can see all 18 Dividend Kings here.
Just because a business is a Dividend Aristocrat or Dividend King does not automatically mean it is a great investment.
Investors should do their due diligence. Check for growth potential, strength of competitive advantage, and valuation. Being a member of the Dividend Kings or Dividend Aristocrats is a starting point, not an ending point, for finding high quality businesses for the long run.
Tip 5: Minimize Frictional Costs
One of the biggest advantages of long-term investing is minimizing frictional costs. Frictional costs are brokerage fees, slippage, and taxes.
You only incur brokerage fees and slippage when you buy or sell a stock. Minimizing the amount of buying and selling you do minimizes the amount of fees you will pay your broker. Every dollar you save in fees matters because of the mathematics of compounding. Every dollar saved today is $2.59 in 10 years and $6.73 in 20 years if your money is growing at 10% a year.
Similarly, reducing the amount of trades you make minimizes your tax burden. Capital gains tax is due when you sell an investment. A long-term investment that is never sold never triggers capital gains tax. You are, in effect, allowing the money you would have paid as capital gains to continue compounding. The savings add up over time due to the power of compounding.
Tip 6: Know Why You Will Sell
When to buy stocks (and what stocks to buy) is constantly discussed in the financial media. When to sell (and why) is rarely discussed.
It is far easier to hold stocks for the long run when you have predefined reasons to sell. Don’t sell because a stock’s price has fallen (or risen). That doesn’t matter.
In The 8 Rules of Dividend Investing, I outline 2 reasons to sell.
One is if a stock cuts or eliminates its dividend. A business that is forced to cut or eliminate its dividend is having cash flow problems. It has likely lost its competitive advantage. This makes it less likely the business will be able to continue compounding your wealth going forward. As a result, it should be sold.
The other reason to sell is if a stock becomes wildly overvalued. The total returns you can expect from a stock are related to its valuation multiple. Stocks with lofty valuation multiples have their earnings growth heavily discounted into the future. The business must perform exceptionally well just to meet expectations.
If one of your holdings sees a big run-up in its valuation multiple, it is generally a good idea to sell and invest in a security that is either fairly valued or undervalued. You should define the price-to-earnings ratio at which you will sell when you make the investment, so you aren’t tempted to sell after a small increase in the price-to-earnings ratio.
It is important to use a valuation metric like price-to-earnings ratio instead of price. Growing businesses will naturally see their stock prices increase as the underlying business grows. You shouldn’t sell your stock in a business because it is growing – rather, you should sell if it becomes overvalued relative to the strength of the underlying business.
Tip #7: Estimate Reasonable Total Returns
Total returns can come from only 3 places:
- Change in valuation multiples
- Change in intrinsic value per share
Dividends are self-explanatory. A stock with a 3% yield is going to give you a 3% annual return as long as it keeps paying its dividend.
When valuation multiples change, the stock price changes. It’s easiest to think of valuation multiple changes in terms of the price-to-earnings ratio. If a stock’s price-to-earnings ratio jumps from 10 to 20 (and earnings-per-share don’t change), the value of your purchase doubles. If this happens over ~7 years, then you would generate returns of around 10% a year from valuation multiple changes.
Change in intrinsic value per share is a fancy way of saying ‘business growth’. Growth should be calculated on a per share basis to account for share repurchases. If a business doubles in size, but reduces your ownership by 50% due to new share issuances, your share of the business hasn’t grown. That’s why it’s so important to look at growth on a per share basis.
Making accurate estimates of returns expected from these 3 sources will help you to see what to expect from an investment.
If a stock has grown earnings-per-share at 7% a year over the last decade, and growth prospects look similar going forward, you should probably expect growth of around 7% a year. If the stock also pays a 3% dividend, you’d expect total returns of 10% a year before valuation multiple changes. Finally, if you expect the valuation multiple to increase at 2% a year over the next 5 years, you’d expect total returns of 12% a year.
Examining the sources of total returns helps investors to make realistic assumptions about how their investments will perform. If you want to outperform the market, don’t invest in businesses with expected returns below that of the market.
Tip #8: Be Patient
Perhaps the hardest aspect of long-term investing is patience. Businesses don’t double in value overnight. Investing in high quality businesses is not an immediately gratifying experience.
It takes patience.
Investors who are able to withstand price volatility and patiently wait for the share price of a stock to match underlying business growth ‘earn’ the returns they deserve. The process takes time.
The rapid nature of the stock market – with changing prices and non-stop news – makes patience a rare commodity for investors.
Charlie Munger calls the ability to be patient ‘assiduity’; literally the ability to sit on your butt and do nothing. It is not easy.
Sometimes being patient means not buying new stocks as you wait for better opportunities to present themselves. Sometimes it means not selling a stock as you wait for the business to overcome temporary obstacles.
Tip #9: Always Get Better (Educate Yourself)
Perhaps the single greatest tip for long-term investing is to continuously educate yourself. The more you learn about investing in general – and long-term investing in particular – the easier it will be to practice this method of investing.
There is no dearth of information on the subject. Books by Jeremy Siegel, Lowell Miller, and Seth Klarman are all excellent reads for long-term investors. Warren Buffett’s annual reports are another source of information.
Finally, examining businesses that have generated tremendous returns over long periods of time is a good way to hone your investing ability. It shows what to look for in future investments. Knowledge is power.