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  • Writer's pictureNicholas Pihl

For better stock investments, focus on these three principles

Updated: Feb 13, 2023

The thing about investing in stocks is, they aren't bonds.

"Well, duh," you say, "obviously stocks and bonds are different. Everybody knows that stocks are typically higher risk, higher reward compared with bonds."

But how so?

That question is key, I think, to becoming a better investor, because it highlights three important criteria for investing in stocks: longevity of the business, opportunities for growth, and risks.

Said differently, you want a business that will still exist in 10 years, that will be significantly more profitable at that time, where you can . With stocks, all three of these considerations are uncertain, particularly when compared with bonds.

When you buy bonds, you have a high likelihood of getting your money back at that future date, you know exactly how much return you'll get, and you know when you'll get it.

For instance, if you buy a 10 year, 3% coupon bond for $10,000 you get paid $150 twice a year (or $300 annually). When the bond reaches maturity, you get your $10,000 principal paid back to you (plus the final $150 interest payment). This assumes no defaults, or bankruptcy, or anything like that, which would mean receiving less than $10,000. But for purposes of this illustration, that's mostly a fair assumption since bonds (in aggregate) are less likely to default than stocks are to lose value.

Stocks are different. Instead of regular, predictable coupon payments, much of the return you get from a stock will come from the difference in price between the day you buy it and the day you sell it. This isn't always a positive number.

Along the way, some (but not all) stocks pay out dividends. Because dividends ultimately come from the company's profits, the amount you receive is anything but certain. It depends on how much money the company makes, and whether that amount grows over time. Some companies will grow their profits and increase their dividends over time, which is nice.

But other times companies will reduce their dividends, or cut them entirely. You saw a lot of companies do this around the beginning of the pandemic, when lockdowns were beginning. These companies were uncertain about their ability to make money in this new environment, and prioritized having enough cash on hand to make it through the disruption. Since many companies were losing money at that time, they were at a very real risk of running out of money. If a company isn't making money, or is losing money, it can't refill the pool of cash that expenses and dividends are paid out of. No profits, no dividends (at least not sustainably).

Contrast that with bonds, where interest payments are very predictable, often down to the specific date, many years in advance.

The downside to bonds is that you don't have much upside. In that 3% coupon example I described above, you earned a 3% return (assuming you reinvested those interest payments along the way), plus your money back at maturity. In a world where inflation is more than 3%, this isn't very attractive because you're losing purchasing power. So it's a pretty certain return, but that doesn't mean it's an attractive return.

The upside to stocks is that the returns can be pretty attractive. At least for a diversified portfolio. Some stocks will lose money, but others have the potential to make a lot of money. And with stocks, the downside is limited. You can only lose 100% (assuming an un-leveraged portfolio). The upside is unlimited. You can earn 2x, 5x, even 100x your money on an individual stock.

This brings me back to my original thought experiment. The ideal investment is one that has all the security and predictability of a bond, with all the upside offered by stocks. Not coincidentally, this is similar to how Warren Buffett picks investments. He favors businesses that have a high likelihood of remaining just as relevant in 10+ years as they are today. This is foundational, and I think for him, non-negotiable.

Buffett often uses his investment in Coca-Cola to illustrate this point. It's a habit-forming product, and consumption is pretty steady from one year to the next. Too, Coke's brand is strong enough that it will probably maintain strong market share compared with other sodas. There aren't many scenarios in which he sees people giving up Coca-Cola. Buffett, of course, has a notorious sweet tooth, and is not particularly health conscious, so take his assessment with a grain of salt. Still, the example works. Coca-Cola will probably exist for many years, even if they have to pivot their product mix towards healthier options.

By contrast, much of Buffett's reluctance to invest in tech comes from the fact that it is harder to predict which of these businesses will still be here in 10 and 20 years. Many cutting-edge companies are profitable only because they have a technological advantage that will eventually fade and become "industry standard." As other companies catch up, these companies risk becoming obsolete. This limits the upside of your stock investment, most of which comes from holding a company for longer than 10 years.

There's a phenomenon known as the "Lindy Effect" which says, in essence, that the longer something has existed already, the longer it will continue to exist. Ergo, the Lindy Effect says it will likely continue to exist for quite a while longer since the properties that led it to survive the massive disruptions of the 20th century will probably help it survive whatever the 21st century has in store. When Buffett says his preferred holding period is "forever," he isn't kidding.

The second pillar of investing in a good stock is whether the underlying company can grow for many years. It rarely makes sense to own stock in a declining company, but if a company can grow for 10-15% a year for many years, the ultra-long-term returns should converge on 10-15% a year.

But again, this growth is secondary to the durability of this growth. Even if a company grows like crazy for 5 years, all that growth is worthless if the company goes bankrupt 5 years later. Or, what happens more often, is that the company's profitability shrinks over time, its growth fades, and it loses the ability to create further upside. In short, such companies become high-risk, low-reward. You'd rather own a bond, in these cases, which at least offers lower-risk for the same, limited upside. Reliability is king.

Thirdly, and perhaps least importantly, you want to buy companies at attractive valuations. This mitigates the risk of losing money in the short and medium terms (2-5 years), and compensates you for the possibility that the company might not have quite the longevity and growth potential you'd hoped for.

Here's a good example of this principle gone wrong. If you'd bought Microsoft in 1999, you'd have spend over a decade under water on the investment. This is despite the company showing outstanding durability and really strong growth over the period. It checked those first two boxes, but ultimately didn't net you any profit for over 10 years.

Maybe I'm just greedy, but I like to see my investments make money a little earlier than that. It doesn't have to be right away (in fact my worst investment decisions have resulted from short-term thinking), but I definitely like to be money-ahead by year 5.

Again though, when it comes to growing your wealth over a lifetime, it's much more important to be right on the durability and growth potential of a business than on the valuation. You want your investment to still exist in year 10, just like you want your principal paid back to you when you buy a bond. Moreover, at year 10, you want your company to have another 10 great years ahead of it, and another 10 years after that, if possible.

For me, I think a railroad is a good example of a company that will still be around in 10 and 20 years. Why? For one, railroads have already been around for over a century and are still the cheapest way to transport goods over long distances by land. There isn't much competition on the horizon, either, since they aren't building many more railways. Buffett evidently agrees, as he bought himself and his shareholders the BNSF railroad back in 2009.

Not that this is a recommendation to go buy railroads, because there are still plenty of ways to lose money on this one. The growth prospects aren't that exciting, and there are still plenty of risks to their long-term business. But it's a good measuring stick for evaluating other companies. For instance, I think Starbucks is probably about as likely to maintain its relevance. But I think a company like Exxon-Mobil is a lot less likely to exist in 30 years.

For situations where you don't have that long-term potential, investing in bonds is probably the better move. At least get your money back.

Finally, there's really no such thing as the perfect investment. Different investors will weight each of these considerations differently. Some will say that since there is no guarantee that any stock from today will still exist in 20 years, that you should focus on stocks that have the greatest upside. The idea here is that the upside of your winners will be more than enough to make up for the downside of your losers. These people are known as "growth investors." To them, durability only matters to the extent that it supports the long term growth prospects. They have a point.

For that same risk, another camp of investors will say that the thing to focus on is a low valuation at time of purchase. They figure that few people can accurately assess the long-term prospects of a business, and focus primarily on reducing the risk that comes from overpaying on an investment. These are "value investors." They also have a point.

Ultimately, it's not worth getting too dogmatic about whether it's better to focus on valuation or growth because investments typically don't fall into one category or the other. Ideally you'd get a really durable business, with a lot of growth potential, at an amazing price. That's Buffett-esque. But usually you have to make compromises in one category or the other. The reason why durability is so important to me, is that it forces me to focus on understanding the business. This helps me understand what its growth prospects really are, and what valuation is appropriate.

Too, it helps to keep in mind that nothing about investing in stocks is certain. Companies can, and do, go bankrupt all the time. You want to minimize the chances of that happening to your investments, and I think the concept of durability is really useful in pursuing that goal. If you can't handle the risks associated with stocks, bonds might be the better option.

Disclosure: Clients of Pihl Financial Planning and I may own shares in the securities mentioned. Nothing in this article is a recommendation to buy or sell. The securities referenced are examples for education purposes only.

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