Tuesday, April 15, 2014

Bullshit financial theories part 4: Higher returns = higher risks

Hey guys, today I will be talking about how the concept of higher returns coming with higher risks is not always right. Before I begin this article, I would like to apologize to my regular readers for not coming up with stock analysis recently. It’s getting more difficult to find reasonably priced companies in this market. I have also been busy lately and it takes a lot of time to research a stock. I will continue to be busy for a little while more, so I might keep serving up Happy Meals instead of Big Macs for the next month or two. Anyway, here’s a quick update on the Greedy Dragon portfolio: I recently bought more shares in Mercadolibre and sold my shares in Kawan Food and Prestariang.

When you think about it, most of the investors that actually made “fuck you money” invested in really good quality businesses such as McDonald’s, Wal-Mart and Berkshire Hathaway. Companies that have a sustainable competitive advantage which allows them to achieve superior profitability generally have very small risk exposures (money does indeed solve a lot of problems). That’s not to say that the shares of good companies won’t experience significant drops in price, they might. But over the long-term, these businesses will consistently make increasingly large buckets of money. When I talk about high grade businesses in this article, I’m referring to the next Nestle: companies that generate high returns on capital and still have a lot of potential to grow. The McDonalds and Nestles of today have reached the maturity stage. While these blue chip stocks certainly have a place in a lot of investors’ portfolios, they’re generally not for me as I’m looking to one day drive a Ferrari and live in a penthouse (of course I will be happy to grab me some blue chips during a crisis when they’re priced as if they’re hookers with STDs).  

Some people might point out that good companies have higher valuations to reflect their lower risk and investors will therefore earn lower returns investing in those companies. But because high quality companies generate high returns on capital, the profits they reinvest work harder and they grow faster. If you could go back 30 years in time and you could invest in Coca-Cola at 20 times earnings or General Motors at 10 times earnings, which stock would you buy? You would invest in Coca-Cola, no question. Coca-Cola was the better business and it is superior business performance that causes superior investment returns (as was the case for Coca-Cola). Just like jeans, cigars and condoms, you’re better off paying for quality. I’m not saying that you should pay any price for a good business, the price must of course be reasonable.

Sometimes you might even get the opportunity to pick up top quality stocks at dirt cheap prices. Let’s be honest, there are a lot of idiots that really shouldn’t be investing in individual stocks. These stupid jackasses will sell their stocks for pennies on the dollars during a crisis, but have no problem with borrowing money to invest in grossly overvalued companies during a boom (don’t question their investment decisions though as they will accuse you of trying to bring the stock down so you can get in on the cheap). But I guess that it’s a good thing that these people are around to fuck up as it gives patient, rational investors the opportunity to move up in life by investing in good companies at deeply discounted prices.

I’m not saying that the concept of high returns coming with high risks is always wrong, a lot of times the concept is right. For example: Investors may get higher returns investing in junk bonds but bear a higher risk of losses as companies with debt rated as junk are more likely to default on their debts. What I’m saying is that I want my portfolio to be mainly geared towards great companies that have low risk and have potential for very attractive returns. That’s where the real money is at. Thank you for reading. Take care and stay rational.      

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