How to do what the finance professors say can't be done...
How to do what the finance professors say can't be done... A simple way to beat the market... Why low volatility is the secret... A 'magic portfolio' that could triple your returns in stocks...
In today's Friday Digest, I'd like to show you an investment strategy that's so simple and so effective, we call it the "magic portfolio." It's a way to guarantee that you will beat the market.
Let me repeat... With this strategy, it's essentially impossible for you not to achieve substantially better results than simply buying an index fund. And by substantially better, I mean double, triple, or quadruple the market's average return.
The outstanding returns aren't the real magic, though. The real magic is that you can achieve these results with much less risk and much less volatility than you would experience if you simply bought an index fund.
I promise... as simple as this strategy is, you have never seen anything like this before. This strategy doesn't involve any trading. You don't need any special knowledge to implement this strategy. And you don't have to read a newsletter, join a fund, or use a special broker. In fact, having less investment experience is probably an advantage when you use this strategy.
You don't need much capital to do this either, because you only have to buy 10 stocks. Even if you only have $1,000 to invest, you can still participate. And the best part is, once you buy the 10 stocks and set up your "magic portfolio," you don't have to do anything else. You're done. You don't have to follow trailing stops or "rebalance." You don't have to pay commissions. You don't have to do anything except to wait for 10 years (or even longer, if you wish) while your capital compounds.
One word of warning: This strategy does, of course, involve buying stocks. And if you're like me and you're concerned about the possibility of a major correction in the stock market or even a worldwide currency collapse, you might wonder if now is a good time to implement this strategy.
You might find this surprising, but I believe that owning stocks is actually one of the best ways to protect yourself from a currency crisis (as I explained recently here). And to show you how well this strategy works to build capital even when stocks crash, I'll show you what would have happened using this strategy over the last 10 years – from 2005 until 2015, a period that included a massive 50% decline in stocks.
You might wonder why I would share such information with you. After all, if you use this portfolio approach, you won't need to buy any of our newsletters. You could cancel your subscriptions, put your money to work in the market using this strategy, and be done doing business with us. And I know for certain that's what will happen with at least some of the folks reading this message.
Nevertheless, after working for investors for nearly 20 years as a financial analyst and newsletter publisher, I'm more committed than ever to accomplish one goal through my work: I want to provide you with the information I'd want if our roles were reversed. I believe that if I make this my main goal, everything else in my business and my professional life will fall into place.
As I often remind you in my Friday essays, there is no such thing as teaching, only learning. So as I explain these ideas, write down a few notes. Talk with your friends and your financial advisor about these ideas. And don't just copy what you see below. Think about how and why it works so well... and then use those principles to design an approach that's right for you.
OK... enough warm up. Here's the secret behind this portfolio approach. How can you define what makes for a great business? If you want to be a safe and successful investor, it makes sense that you would want to buy the world's best businesses at a fair price.
But how do you define what that means? And how do you know you're buying a stock at a fair price? The whole secret behind our "magic portfolio" approach is that while we put a few objective requirements down, we allow the market to tell us which stocks are actually the safest to own – the highest quality.
Ten years ago, if you were looking to buy only the highest-quality stocks available, how would you have gone about finding them? The first thing you would measure is profitability. If you're looking for a safe investment, you want profitable companies. For our "magic portfolio," we insist on operating margins of at least 15%. That means these companies earn at least $0.15 in profit (before taxes and depreciation) on each dollar of revenue.
We exclude those factors (which are important) so that we can study different businesses across many different industries, which have different accounting rules that can either inflate or artificially deflate profitability. This 15% figure is arbitrary. We picked it based on our own experiences in business. High-quality businesses ought to be able to earn profits of at least that level every year.
Lots of analysts use operating margin as a kind of first-step litmus test. There's nothing "magic" about that part of our approach. The real magic comes next. Rather than attempting to do a lot more qualitative or quantitative analysis, we simply allow the market to tell us which stocks are the safest. We do that by looking at what's called "beta." Don't worry... this is the only real jargon you need to understand to set up a "magic portfolio" of your own.
Beta is a Greek word that's used in financial statistical modeling to mean volatility relative to the stock market as a whole. What a stock's beta tells you is how it moves – up and down – relative to the stock market as a whole. Companies whose earnings and business models are the most proven and the most solid have lower volatility than stocks with less-established businesses and weaker franchises.
Want proof of this idea? Well, out of all of the stocks with good profits from 10 years ago, guess which stock in the U.S. had one of the lowest betas? It was Berkshire Hathaway. Warren Buffett – the greatest investor in history – leads Berkshire. It is a collection of immensely profitable insurance firms and super-high-quality operating businesses.
Berkshire's balance sheet is one of the world's most secure financial flagstones. It's no surprise that Berkshire's share price doesn't move around nearly as much as the stock market as a whole. In fact, 10 years ago, Berkshire had a beta of 0.69 – which means it was more than 30% less volatile than the stock market as a whole.
Now... here's the really interesting part. Modern financial theory teaches students in business school that risk (as defined by beta) is related to returns. Finance professors all over the world still believe that you cannot earn market-beating returns unless you're willing to take excessive risks. That is, most investors still believe that to earn great returns in stocks, you have to own a risky and highly volatile portfolio.
But in our experience, that's simply not true. After working with actual investors for almost two decades, what we have constantly found is that investors who own the least volatile stocks tend to do best, if for no other reason than they have the confidence in their investments to continue to hold them.
Just look at Berkshire Hathaway. This is one of the highest-quality businesses in the world. It is dramatically less volatile than the stock market. For nearly its entire existence, it has beaten the stock market every year. (Lately, this hasn't been true, which is the subject of a book I'm writing, titled Warren's Mistakes. You can read the first chapter here.)
Over the last 10 years, Berkshire has earned its investors 10.1% annually – beating the market's 8.5% return significantly. That amount of outperformance adds up to huge differences in total returns over long periods of time.
That's why we call these stocks "magic stocks." They give investors a "free ride." They deliver both excess returns and offer lower volatility. Financial theory says this shouldn't happen. But it happens all the time. And it happens with stocks that are easy to find, easy to understand, and totally safe to own. Let me show you exactly what I mean...
Ten years ago, if you would have gone looking for great stocks with just four qualities –low volatility (20% less than the stock market), high profit margins (of at least 15%), a reasonable price (a total market value around 12 years' worth of cash profits or less), and well-known and highly regarded brands – you would have found these 10 investments:
|
2005 Magic Portfolio
|
||||
|
Stock
|
Industry
|
Beta
|
Annual
Return
|
Adjusted Position
Size
|
|
Berkshire Hathaway
|
Insurance
|
0.69
|
10.0%
|
10%
|
|
Altria
|
Tobacco
|
0.64
|
19.4%
|
11%
|
|
McDonald's
|
Fast food
|
0.68
|
15.8%
|
10%
|
|
Colgate-Palmolive
|
Soap
|
0.66
|
12.9%
|
11%
|
|
Monster Beverage
|
Beverage
|
0.74
|
43.1%
|
8%
|
|
AutoZone
|
Retail
|
0.64
|
23.8%
|
11%
|
|
Merck
|
Health care
|
0.76
|
9.8%
|
8%
|
|
Johnson & Johnson
|
Health care
|
0.71
|
7.0%
|
9%
|
|
Stericycle
|
Health care
|
0.53
|
20.0%
|
15%
|
|
Sherwin-Williams
|
Paint
|
0.77
|
22.5%
|
7%
|
|
Portfolio Metrics
|
|
|
Beta
|
0.68
|
|
EBITDA Multiple
|
9.4
|
|
Operating Margin
|
21.6%
|
|
Capital Efficiency
|
7.1%
|
|
Total Annual Returns
|
|
|
S&P 500
|
8.5%
|
|
Magic Portfolio
|
18.4%
|
|
Leveraged Magic Portfolio
|
20.9%
|
I understand that one rear-looking example doesn't "prove" anything. But here's the thing... These kinds of stocks don't just beat the market by a little. They trounce it. And the reason they beat the market is fundamental to their businesses. It's not because of some lucky break or new widget. All of these companies have truly elite businesses. They are able to consistently generate big profits, and they don't require much capital to grow because they are so well-established. That's why there's so little volatility in their share prices.
And why do they beat the market so easily? Look at their capital efficiency. Regular Digest readers know this is a measure of how much cash a company is able to return to its shareholders each year, displayed as a percentage of total revenues. For every dollar these firms made, they were able to return $0.07 of the revenue directly to shareholders. That's like starting out every year with a 7% return. It's hard not to beat the market every year with an advantage like that. (And you should note, this portfolio includes Berkshire Hathaway, which famously refuses to pay a dividend.)
Again, although this example is "rear looking," if you went back and looked at the data from 10 years ago, you would see that these stocks are the 10 most profitable, most reasonably priced companies that have extremely low betas (low volatility). There was no cherry-picking or data mining.
Now, here's the advanced course...
What if making 18% a year wasn't enough for you? What if earning more than double the market's return didn't meet your financial needs? Is there a way to use this "magic" approach to make even bigger returns? Yes, there is...
If you wanted to make even bigger returns, you could add leverage to this "magic portfolio." Adding leverage normally makes a portfolio much more volatile than the S&P 500. But with these stocks, because we're starting from such low volatility, you can actually add significant amounts of leverage and end up with a portfolio that matches the average volatility of the stock market. In other words, you can increase your returns without exceeding the risk of the S&P 500.
We made some adjustments to the portfolio like you would if you were going to leverage it up. First, we normalized the volatility of each position in the portfolio by adjusting position sizes. You can see the weight of each stock in the above table under the "Adjusted Position Size" column. All we're doing is slightly trimming the more volatile positions while adding just a bit more capital to the most stable stocks.
In this way, each of the 10 positions contributes the same amount of risk to the portfolio. Then, each position gets "levered up" by borrowing money (roughly 30% of the equity) and increasing the size of the position until its volatility is equal to that of the S&P 500. These actions increase the annual return of this super-safe portfolio to more than 20% annually.
Listen... If you don't understand the advanced course about changing the position sizes (slightly) and adding leverage, don't worry. My own analysts continue to debate the best way to restructure these portfolios using leverage.
But the overall point is what matters. By looking for high-quality, low-volatility stocks, you end up finding excellent investments – far better investments, on average, than you will get buying the market as a whole. This strategy turns financial theory on its ear.
So if you wanted to build a "magic portfolio" today? Which stocks would you buy?
|
2015 Magic Portfolio
|
||||
|
Stock
|
Industry
|
Operating
Margin
|
Price
Multiple
|
Capital
Efficiency
|
|
Amgen
|
Biotech
|
33.8%
|
15.1
|
25%
|
|
Altria Group
|
Cigarettes
|
36.3%
|
13.9
|
19%
|
|
Procter & Gamble
|
Household products
|
19.0%
|
13.0
|
16%
|
|
Philip Morris
|
Cigarettes
|
41.1%
|
12.4
|
34%
|
|
Clorox
|
Household products
|
17.1%
|
12.0
|
15%
|
|
Johnson & Johnson
|
Pharmaceuticals
|
25.6%
|
11.2
|
17%
|
|
McDonald's
|
Fast food
|
27.7%
|
10.9
|
21%
|
|
AutoZone
|
Auto parts
|
18.0%
|
10.5
|
14%
|
|
Chubb
|
Insurance
|
21.7%
|
7.9
|
16%
|
|
Coach
|
Jewelry
|
32.1%
|
6.7
|
23%
|
|
Portfolio Metrics
|
|
|
Beta
|
0.80
|
|
EBITDA Multiple
|
11.4
|
|
Operating Margin
|
27.2%
|
|
Capital Efficiency
|
19.8%
|
Note: All figures above are based on 10 years of data, except the price multiple. Price multiple is a measure of value. The lower the multiple, the cheaper the stock. It's calculated by dividing the total value of the enterprise (all shares outstanding plus all net debt outstanding) by the current year's operating earnings.
My Investment Advisory subscribers might notice something: Many of these stocks have already been recommended in our portfolios. The cheapest stock in the list – Coach – was my top stock pick this year. It's one of the best investment opportunities I have ever seen in my entire career.
If you look closely at the list, you'll notice that we had to "pay up" for some of these stocks. Amgen, Altria, and Procter & Gamble are all trading for more than we would prefer to pay – more than 12 times their current cash earnings. However, these firms possess so much capital efficiency, we believe they are clearly worth more than the other firms on our list. Even so, on average, this portfolio trades for less than 12 times the combined operating earnings, a price we believe is fair and reasonable.
I believe the portfolio above will trounce the stock market. I believe it will earn at least double the annual returns of stocks, on average, over the next 10 years. It will be difficult (if not impossible) for individual investors to do better than this in stocks.
Likewise, few professional investors will produce results this good in stocks over the next 10 years. And the most wonderful part of this strategy is that all of these firms are well-known. Buying these stocks will make sleeping well at night easy. These companies are extremely safe to own. This portfolio will surely be a lot less volatile than the market as a whole. If raw performance is your goal, you could easily employ leverage inside this portfolio to significantly increase your returns.
These are the types of stocks we often cover in my Investment Advisory.
And my latest recommendation is an extraordinarily capital-efficient company operating in one of my favorite industries. This is the type of company you simply buy and hold for 10 years and make giant profits.
As I said in my issue... "No business in the world has the odds stacked more in its favor." And our sources tell us this company – and similar firms in its industry – are ripe for a takeover.
If you're not already a subscriber, you can try a 100% risk-free trial to Stansberry's Investment Advisory for less than $50 a year. You can try it for a full four months before deciding if it's right for you. Click here to learn more.
New 52-week highs (as of 4/23/15): CDK Global (CDK), Dollar General (DG), SPDR S&P International Health Care Sector Fund (IRY), Kinder Morgan (KMI), Rigel Pharmaceuticals (RIGL), and Varian Medical Systems (VAR).
What do you think about this "magic portfolio" strategy? Will this approach really lead to excellent investment performance? If it works, why would investors do anything else with their savings? Let us know your thoughts at feedback@stansberryresearch.com.
"I have read so much of what you have written over the last few years and it always makes sense to me. Like you I had always wanted respect of my peers. I am a retired web developer and I started doing it when I was 40 something when it was consumed by young guys in their 20s. Over those 17+ years I got to enjoy that respect. Trust me Porter, you already possess that respect by so many.
"From my perspective, those many hours that you do what you do are no different than I. I am up at 5:30 AM and rarely am asleep at 10 PM. I am 69 years old and always busy doing something. It is nice to do business with someone that sees the world the way I do. If it wasn't for End of America we would never have been doing business. What Stansberry has given my family is financial safety, confidence in the investments that are made or investing just to do it. You have given my wife a sense of financial safety. Needless to say that means everything to me. Thank God you never sell yourself short. Wanting to be the best at whatever is so very important." – Paid-up subscriber Jeff Spranger
Regards,
Porter Stansberry
Baltimore, Maryland
April 24, 2015
