Eliminating Investment Risk
It’s remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.
— Charlie Munger
Last month, I wrote about my goal of becoming cancel-proof, and I announced I would share the things I learn on Medium for other folks to borrow. The long-term goal is to create a passive income for myself by investing in companies that pay good dividends. The focus of this post will be on the first principle of value investing: the elimination of risk.
In the quote above, Munger refers to the wealth he and Warren Buffett have attained not by chasing growth promises but instead by focusing on the elimination of risk. Value investors like them believe that by avoiding risk, they don’t have to worry about losing their capital and thus always have an opportunity for growth. If your investment fails and loses money, that puts you in a much worse position for future investing, after all! Therefore, we will talk about key ways to avoid risk when investing in companies that can give you a passive income through their dividends.
One of the best ways to eliminate risk is to make sure that a company does not have too many debt problems. The reason is pretty obvious. A company is obligated to pay off its debt before distributing earnings to owners. Even worse, if a business goes broke, the creditors get first dibs on the remaining cash. You can’t count on steady dividends if your company has obligations to someone else, so if a company can be profitable with very little debt, that bodes well for you as an owner.
Is the equity positive?
This is an easy one that should be a good start. If you remember learning about assets and liabilities in high school business class, this is talking about the same thing. Is the value of the total liabilities (debts and obligations) a smaller number than the total assets (properties, tools, buildings, other things owned)? In short, if the business needed to close up for good and sell everything off, would there be money leftover after covering the liabilities for you as an owner to collect? If not, you want to buy after the company has fixed this problem. Even successful companies, like Starbucks currently, can have negative equity. I used to work at Starbucks, and I know the popularity of its brand. I still won’t buy its stock.
After determining that the equity is positive, you still want to be sure that debt levels are manageable. Two great metrics for this are the Debt-Equity Ratio and the Current Ratio. D/E Ratio takes the current debt (total debts to be paid within the next twelve months) of the company and divides it by the total equity. A good company will have a D/E under 1. A great company will be below 0.5. Remember, though, if the D/E is negative, that means the equity is negative!
The Current Ratio gives a similar diagnosis. Current Assets are cash (or things soon to be cash) within the next twelve months, while Current Liabilities are obligations to be met within the next twelve months. A good business will have a CR above 1, but a great company will have a CR above 1.5.
If a company does well on these ratios, it indicates that you’re likely to receive a piece of the earnings as an owner and thus not waste your money in the wrong stock. In general, you’re better off buying a great company at a fair price than a good company at a wonderful price, as the great company will actually pay.
While you’re at it, drop your credit cards and lower your own debt. Why pay interest when that money could be spent on investments?
No, this isn’t blind patriotism. This is just a reflection of which economy is the most successful and stable. America has seen tremendous growth and development in the last century. It is one of the safest places is in the world, not only in terms of domestic violence, but its military might is also unrivaled. There are no migrant crises or spillover wars; it is guarded on two sides by the Atlantic and Pacific Oceans, which the United States Navy patrols and protects. Internal conflicts were mostly settled in 1865, and the current state of political partisanship does not compare to that or other divisions across the globe.
Europe, meanwhile, has its struggles. The 2010s showed cracks in this post-war promise. There was the Eurocrisis in the 2010s, the spike in nationalism, the Syrian migrant crisis, the secession of the United Kingdom, and the continued corruption in Eastern European governments. In America, the dollar is stable, the 50 states are still united, and reports filed to the Securities and Exchange Commission can be trusted as the most accurate in the world.
The American experiment, with it successes, removes uncertainties that plague the investor. Whether you are American or not, to avoid the loss of capital, you must minimize risk, and therefore you must buy companies whose futures are guaranteed by the stability of their home nation. America promises this better than any other place.
Don’t Chase Growth
Plug Power is an interesting company that has garnered attention in the last year. Priced at just over $4 per share a year ago, it’s now over $60 per share. A few months ago, a friend of mine was wondering if he should buy it, since it was growing so much. I asked him if he thought the company was actually worth that much per share, especially since it hasn’t earned a profit in 20 years. Buyers are excited about it, but a company that has no earnings isn’t going to give you a passive income through dividends. Only profitable companies pay dividends. Buying a popular stock just means you’re buying something that became more expensive in the hopes that it will become even more expensive. You should be so lucky!
The price of a stock on the market is not its intrinsic value. This is merely an offer. You can buy or sell a stock at that price, and tomorrow you will be given a different offer. Your job is to decide if the price is worth it at that time, and you make that decision by studying the company’s fundamentals. Are its cash flows positive? Does it pay a steady, rising dividend over time? Did it maintain strong numbers during recessions?
At the current share price, Plug is currently trading for $30 billion on the stock market. Its dividends are zero. Its free cash flows are consistently negative. There are no signs that this will change. If the entire company were liquidated today, the owners would get about about $0.45 per share. Plug was already overpriced about a year ago, and now it’s about fifteen times more expensive to buy.
Aflac, meanwhile, has no debt problems, is consistently profitable, and has increased its dividend for a straight 38 years. Which company would you rather buy?
That’s all for this time. Let me know what you think in the comments.