Dividend Growth Investor Newsletter

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Wednesday, October 23, 2024

Bets and Setups

Success in investing is easy to compute. You either make money overall over a certain period of time, or you don't.

If you do make money investing, that's the end result of the aggregate amount of profits (capital gains + dividends) on the winner side, exceeding the aggregate amount of losses on the loser side.

If we continue to break it down further, we may end up with a few more useful statistics.

It is important to understand that not every investment you make will be a successful one. 

However, if your profits on the winners exceed your profits on the losers, you will come out net positive. 

So it is important to understand how many of your positions will be profitable over time, as well as how much you make when right versus how much you lose when you are wrong.

Peter Lynch has also famously said that if you are right on 4 out of 10 investments, you can still generate a good track record. He also noted that when you invest money in a stock, the most you can lose is the amount you invested. The most you can make is roughly unlimited however.

Let's play with some numbers.

Imagine that you are a buy and hold investor. You are right 40% of the time on average.

You invest $1,000 each in 100 companies over the course of your investment career. 

This means that 60 of those companies would likely lose money for you. But 40 of those companies would make money for you.

Now, if you lose $500 per company when you are wrong, that translates into a lifetime loss of $30,000.

This means that your profitable investments need to generate a profit of $750 each on average, just so you can break even. This means that at this percentage of profitable to losing investments (40% Winning), your average gains ($750) have to be 1.5 times the amount of your average losses ($500), just so you can break even. 

It's a fascinating way to think about things. You can feel free to substitute the percentages for winning investments versus percentages for losing investments, along with the amount of dollars you make per winning investment versus amounts you lose with losing investments.

When you have the data, you can try to play more with the numbers, in order to see if you can improve your overall chances of making money.

For example, if you manage to reduce the impact of losses, your overall lifetime gains will improve. If you also manage to improve your winning percentage, your overall lifetime gains will improve. If you manage to maximize your average impact of gains, your overall lifetime gains will improve.

This of course is a lifetime calculation, but to keep it simple I ignored inflation, taxes etc. Mostly because we are discussing a basic concept, and do not want to dillute things further with more data that won't add much more to the original concept.

In the above example, we determined that each profitable investments need to generate a profit of $750 each on average, just so you can break even. 

However, if you are in the habit of simply selling when your investment doubles, your $1,000 investment turns to $2,000 and is cashed in (on the 40 investments you made). Hence, your overall profit is $1,000 times 40 minus $500 times 60 for a net overall lifetime profit of $10,000.

That's great on paper. But then we get the next logical question. What if you don't simply sell when your initial investment doubles.

I believe that for a long-term strategy, it is imperative that you let your winners run for as long as possible. The distribution of outcomes will vary. Some companies would really succeed, and pull up the average profit. Those tails will drive results.

If you let winners run, versus locking in a quick profit, you improve your chances of making more money. If letting winners run results in an average profit of say $1,250, that improves overall profitability.

In addition, if you manage to cut losses, you may also improve overall profitability. 

It's helpful to think through those scenarios, not because of precision, but because they make ask yourself to understand your strategy better. And hopefully improve from there.

For example, a long-term buy and hold strategy would not have a high percentage of investments that are right. Let's assume it is 40%, though it could be lower too. This is why you need to work to minimize losses when you are wrong, as much as possible. But it is really imperative that you simply hold for as long as possible, and milk this for as long as possible, in order to stand the maximum chance of maximum profit.

This to me is what thinking like a business owner feels like, when it comes to investing.

I went through all of those numbers and scenarios to essentially get to Set-Ups. 

A set-up is a combination of factors, or reason to invest, that lead to you taking an investment.

My setup, aka my entry criteria for dividend stocks looks like something like this:

1. A long track record of annual dividend increases

2. Earnings growth over the past decade

3. Dividend growth over the past decade

4. A payout ratio that stays in a range, and is not too high

5. A valuation that is not too excessive

This is a high level overview. If we really get into the details, you'd see I think more about trade-offs between yield and growth, interest rates and valutions, how cyclical a company's earnings stream is, as well as whether to add to an existing company versus a new one based on portfolio weights. Valuing companies is more art than science. Deciding which company to add to on my spectrum of opportunities is another type of art/science connundrum.

But let's get back to set-ups. 

For example, I have determined that if I can buy a company growing at X and a valuation of Y, I can make money. This means that I make money on average, but not every set up or every signal will result in a profit. I do need to manage to overall profits and losses, in order to make money. 

There is less emphasis on each individual company working out, because that outcome is impossible. The emphasis should be instead on the aggregate of those companies working out. This is a smarter and more sustainable approach, as it shifts your mindset from one that is overly concentrated and swings for the fences type, to a more long-term, slow and steady one.

The important thing to remember is while not every set-up will work, overall the strategy would likely work, for as long as one makes more money on winning investments overall than what they lose on losing investments overall. To tie back to the initial discussion, if you end up making 100 investments over your lifetime, each of $1,000.

Then 60% of those investments lose half of their value, you "lost" $30,000. But if the remaining 40% ended up being all tenbaggers, you made $400,000 on the winners. Overall, you made $270,000 profit.

This of course is all hypothetical, but mostly to illustrate the point to take your signals, and not miss them. Do not be discouraged that all investments won't work out, for as long as some do, you should be ok. It's also important to avoid taking "quick profits", but to let winners win for as long as possible. It's important to minimize losses as well. It's also important to monitor portfolio, and try to learn from mistakes and improve continuously and over time. Continuous learning and improvement is how one can improve their odds of success.