By Andy Flattery, CFP®, 3/2021
"Find good companies and hold those positions tenaciously over time to yield multiples upon multiples of your original investment." - David Gardner
I would like to offer you a different perspective in the way you view investing in stocks. Because it is my belief that yes, you can own individual stocks in your long-term holdings. While some financial advice tells you that mutual funds, ETFs, and robo advisors are your only option, I think they are missing the mark.
Here are the main arguments I will make in this piece:
First and foremost, let’s start with the end in mind. Why we invest will be different for everyone, but perhaps there are a few things that most of us have in common. A few examples:
Regarding the first point, I need to tell you my favorite story of how the generations can be impacted through astute investing. My friend Ryan O’Connor, Founder and Portfolio Manager at Crossroads Capital in Kansas City, grew up under the tutelage of his grandfather, Bill O’Connor. Bill had the good fortune to meet Warren Buffett himself as a younger man in Omaha. Given the opportunity to invest in Buffett’s early partnership, he took the chance and had the forbearance to stick with that investment over many decades.
Needless to say, this arrangement worked out very well for the O’Connors and a small initial investment grew into a fortune. Here is Ryan, in his own words:
if my grandfather got his first real lessons in investing from Buffet, I got mine from him. They started as far back as I can remember. His early lessons were simple and full of “the acorn grows into a tree”-style metaphors; eventually we moved on to the Rule of 72 and more advanced topics. I heard them all more times than I can count. For my tenth birthday, he gave me a copy of The Richest Man in Babylon.
If you would like to hear the entire story, I would encourage you to check out my podcast interview with Ryan here. My favorite part is that the O’Connor clan would go on to produce over 70 grandkids. All of these grandchildren, especially Ryan, would benefit greatly from the work of their grandfather through a paid education, gained wisdom, and more. His persistent dedication to simply holding had impacted his generations down the line. We can all hope and dream to follow in the footsteps of men like Bill O’Connor!
Of course, the obvious rebuttal is that the chances of any of us meeting another Warren Buffett anytime soon are slim to none.. Forget about it! But if you think that is all there is to gather from this story, you’re missing a few crucial points.
The biggest lesson is that this is real investing that has produced the greatest results for the most amount of regular folks, including Bill O’Connor. As I write this in February of 2020, the rage is all about everything but real investing. Instead, the focus is on a grab bag combination of:
The heroes of our day are crypto bros and pitch men influencers that may remind one of The Wolf of Wall Street’s Jordan Belfort. Actually Jordan Belfort is back at it again, come to think of it. Personally, I want to run as far away from this gambling mentality as possible.
Conversely, the “smart money” heroes are quants like Renaissance Technologies’ Jim Simons, who was coined The Man Who Solved the Market. But are people like Simons really investing? Because I can’t personally relate to much at all that he does in financial markets. As Chris Mayer put it:
"investing for me starts with understanding individual businesses… trying to value them… buying them at a good price… and, ideally, owning them for a long time. Simons does none of this. His fund specializes in doing things like buying futures contracts, commodities, currencies, bonds and stocks because a computer algorithm found that it was good to buy on certain days at certain times or whatever. Many of these recurring patterns made no logical sense – i.e., the outperformance of stocks that start with the letter A…"
If this description strikes you as opaque and baffling, I agree. This is why it is time to get back to the basics.
Back to basics investing is about buying great businesses directly and holding on. Personally, I own companies in my portfolio that I intend to hold for 10 years+, hopefully much longer.
I have seen the great fruits of this concept firsthand from older investors I have met over the years. Most of the time, these investors were not brilliant academics, but regular folks that purchased investments decades ago and just never sold. Did they always outperform the market? I have no idea (and I’m not sure that it even matters). I can tell you that they did well for themselves. They achieved their long term financial goals. Many professionals like to chalk up stories like these to luck, but let’s not jump to conclusions.
Because the prudence to buy shares in a quality business and hang is now a sort of timeless virtue. Here we can look to historical examples such as the 2000-year-old wisdom found in the Jewish Talmud of investing our wealth “a third in business,” the first joint stock companies in medieval Christendom, or in the first stock markets that arrived in the 17th century Dutch Republic. Investing in great businesses isn’t going anywhere.
Warren Buffett, in tackling this problem, has famously opined that the vast majority of people should simply own index funds. And indeed he did say this, so is that the end of this story? Buffett himself is an active manager, meaning he makes his own judgements on investments, he is not merely a passive participant.
No doubt, the mainstream will continue to push for index investing as the best solution to this problem. Perhaps they are correct. My intention here is not to tell anyone their strategy is wrong. There is more than one way to win in investing. Rather, I’d like to offer an alternative path for those that want to reclaim a foundational strategy for their investing decisions.
Because as dissident academics like Lasse Pederson, Mike Green, and others have aptly pointed out, index investing comes with it’s own set of troubling issues, such as:
"If everybody indexed, the only word you could use is chaos, catastrophe…The markets would fail." – John Bogle, May 2017
Do these concerns mean that index funds will underperform or even crash? Not necessarily. In fact, many of the reasons that index funds are problematic are the same reasons that these products may continue to do well! But I know that I personally sleep better at night by avoiding index funds with my investments.
But, to whom shall we go? One answer is to humbly work to become real investors, not merely consumers of financial products like mutual funds and ETFs. Common stocks, after all, are ownership shares of businesses. This will be hard work, there are plenty of reasons not to even try, but the rewards could be worth it.
In 1984, young John McDonald wandered into a bar while vacationing in Europe. On this trip, he would discover something that would change the direction of his life. That thing would be an encounter with the miracle of Belgian beer. These beers impressed him greatly with their aroma, flavors, and sheer variety. It is getting harder to remember this era today, but this was a time of bland, commoditized, and unremarkable beer back in the States.
One of the reasons was because there were fewer companies than ever brewing beer. The few American brewers around in 1984 essentially produced the exact same product.
To put it in perspective, at one point in time Kansas City alone had over a dozen breweries itself. The United States once boasted over 4,000 breweries in total! But by 1984, the market had shrunk to less than 50 active brewing companies.
Beer, as it was, had become a commodity.
McDonald recognized the need to deliver a product that was for beer lovers, a demographic that was criminally underserved during this era of oligopoly. So he built a brewery, started experimenting, and by 1989 had his first keg produced of Boulevard Pale Ale.
In case you haven't guessed it yet, John McDonald had started Boulevard Brewing Co in Kansas City. He was on the ground floor of the craft beer revolution in the U.S.
This story may sound vaguely familiar to anyone today with an IRA or 401(k) plan. How often do those of us that work in financial services hear the trope that a “portfolio is a commodity?” The advice that we hear most often to simply look for the lowest expense funds.
After all, most Target Date portfolios found in 401(k) plans today are some variation of the global 60/40 portfolio, managed by committee, with mutual funds allocated by way of a glidepath, and/or an algorithm. Sophisticated, but homogenous.
To be clear, there is nothing wrong with these portfolios, per se. I can appreciate a dependable Coors Light just like anyone. But isn’t there room for some variety? After all, the fast growing ETF market is dominated by a mere three companies today.
Investing needs a craft beer movement.
But I thought stock picking was a foolish errand? This is certainly the mainstream view.
No doubt, investing in stocks in any way is a challenge and should be approached with care. We all make mistakes. A lot of craft beers are awful, to be sure.
Likewise, on this journey you will come across demoralizing academic studies and learned professionals telling you that you are a foolish speculator. Many of them are well intentioned. Others are “talking their book.” If you don’t have a single contrarian bone in your body, this sort of investing framework is probably not for you. That is okay too! Surely, there is more than one way to win in markets.
A key to unpacking this conflict is in two ideas that are well-ingrained today, those are Modern Portfolio Theory and the Efficient Markets Hypothesis. As a professional who works in financial services myself, I can say without reservation that it is unorthodox to voice an opinion outside of “the cathedral” of MPT & EMH. There is reason to think that perhaps you should though.
Modern Portfolio Theory is the idea of assembling a portfolio of assets so that the expected return is “maximized” for a given level of risk. If you have ever seen a chart of an “efficient frontier,” you have encountered MPT.
Of course, it will always be true that prudent planning is to decide on an investor’s appropriate allocation to stocks, bonds, cash, and alternatives, so no argument there. The issue arises when Modern Portfolio Theory is used in a way that promises a higher degree of precision than is possible.
Ryan O'Connor said it well:
But the idea that it’s possible to reliably and precisely estimate risk and return levels over a defined period for a large number of finely-sliced asset sub-classes – let alone for particular funds –is laughable to anyone who’s ever actually managed a portfolio. And yet vast numbers of investment professionals have based their careers on the assumption that it can be done.
Likewise, the Efficient Markets Hypothesis is the idea that investors make rational decisions, market participants are sophisticated, and act only on available information. To follow this to its conclusion, it’s the idea that you can never really buy a stock for a bargain. In the words of Malkiel, a “blinded monkey throwing darts” would do just as well.
But there is plenty to scratch your head about with EMH too. Eugene Fama, the Chicago School professor who pioneered this field, has used curious language about asset bubbles that should give us reason to pause. Fama, although a brilliant thinker, has yet gone as far as to suggest that said asset bubbles exist only in hindsight. As someone who came of age during the 2008 financial crisis, I will never understand this confusing way of describing an obvious phenomenon. Asset bubbles are as old as financial speculation itself.
In my own humble corner, I don’t want to be a naive empiricist. Methodology should matter too, not a blind following of backtests. Or for some, talking about “50 years of academic research” may be a seductive enough charm to not ask too many questions. But lately when I see talk of “the science of investing,” I say instead “the pseudo-science of investing.”
To Fama’s credit, he also welcomed a dissenting voice in Richard Thaler to his own institution, the University of Chicago. Thaler is a pioneer of Behavioral Finance and does not believe that markets are efficient in the same sense that Fama does. This has opened good debate on this topic and shows that there is still a lot to gain from reading academic literature.
It comes down to uncertainty. The truth is that there is more uncertainty in the world than acolytes of the MPT and EMH religion would have us believe. Uncertainty is part of the human experience. Instead of resigning to passivity, we should turn on our brains and adopt active positions.
It is okay to have an opinion.
John Maynard Keynes, despite his flaws as an economist, was a terrific investor in his day. Deciding that making “calls” on the future of the broad economy was too challenging, he concluded that broad passive investing in markets was folly:
"As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little." - John Maynard Keynes (Keynes the stock market investor, chambers)
Keynes had become an investor in individual stocks. He had gone back to the basics as an investor.
Because it is not a “stock market,” it’s a market-of-stocks, as they say. While these stocks achieve returns in the near term that are often random, over the long-term the success of the business tends to translate into success for the stock.
I have witnessed a number of “black swans” market events in my career, such as the 2008 financial crisis, the 2010 flash crash, and the 2020 COVID-19 scare. Like the observation of Keynes, predicting these events with precision would have been challenging or impossible. Furthermore, these encounters were firsthand evidence that extreme diversification is not a safeguard against portfolio losses. In a panic, all stocks are punished equally and indiscriminately.
To be sure, a concentrated portfolio of stocks, however great, can be very volatile. But I would rather bet on entrepreneurs and businesses that merit my trust during times of uncertainty. This principle seems more concrete to me than a belief in the more ambiguous conception of “markets.” It is not our God-given right that “stocks always go up,” after all.
This means that I do not necessarily need to be optimistic about America or the global economy when thinking about the prospects of my portfolio. Instead, I need to be optimistic about the individual businesses and entrepreneurs of my holdings themselves.
Amateur investors have always had advantages over professionals: They can invest for the long run and ignore the short term, since they can’t get fired for underperformance and don’t have clients who give them money (or take it away) at the worst time. - Jason Zweig
The exciting thing about choosing this path in investing is that there are certain advantages that regular investors have over the pros. Here are the top 3 advantages that you have over both Wall Street and Index Funds:
The most successful investors of all-time have almost by definition been willing to stick with their picks longer. My favorite example of this is the story of Joe Rosenfield, who turned the endowment at tiny Cornell College into a powerhouse. He did it by simply buying a few great investments and never selling them. The ability to hold on was an edge that put Rosenfield ahead of Wall Street firms and indexers.
"10% of successful investing is finding a great investment. The other 90% is not selling them." - Ian Cassel (@iancassel) February 7, 2021If you have decades to grow your wealth, you should be pouncing on this advantage. Although it seems obvious that longer holding periods can lead to better results, the truth is that most do not have the patience. In 2020, the average holding period of a stock, which had been declining for decades, was only 5 ½ months!
The beautiful thing is individual investors do not have to “perform” well all the time. You need to perform well over the decades, so who cares about the last quarter? The professionals, on the other hand, are in the rat race trying for short-term results.
Robert Olstein put it this way:
“The desire to perform all the time is usually a barrier to performing all the time.”
Which brings us to the second reason advantage that individual investors have over the pros, a lack of career risk.
So let’s break this down. Your goal as an investor should NOT be to grade yourself against the S&P 500 every year. This makes you very different from those in the business of asset management.
Because even the greatest investors of all-time have had periods where they have trailed the market, putting themselves at risk of getting fired by their clients (if they had clients). Wes Gray went as far as to say that “Even God Would Get Fired” as an active manager. Blasphemies aside, he nailed it with that analogy. Because even someone with perfect foresight, aka “god,” would experience periods of drawdowns, even in those very stocks that would achieve the best returns over time.
There are periods where great stocks simply go sideways, while the rest of the market takes off. Here, boredom can be another challenge for professional investors, who would be compelled to sell great businesses to “keep up.”
Individual investors? You don’t need to gamble that way with your holdings. Act like an investor and not like those who are in the business of investing.
Another advantage that individuals with small amounts of capital have is that it is easier to find winning investment opportunities when you don’t run into the problem of scale.
In Patrick O’Shaughnessy’s words, it comes down to either “Alpha or Assets.” This problem of scale is overlooked by conventional advice though. We normie investors are encouraged to invest in hundreds of stocks through indexing. Likewise, we are told to copy the portfolios of large institutions, such as David Swensen’s Yale model (all the rage earlier in my career). Perhaps we should be doing the opposite.
Because what may be right for Yale is probably not right for individuals. As an investor, you can go places and do things that the institutions and the index funds cannot, such as:
While most of the world is using indexes to own stocks, especially the institutions, you could focus on the investments they are overlooking. I like how Geoff Gannon puts it here:
"If indexing inflates the value of some stocks, then stocks that aren’t in the index will do better (over the long run)."
To be clear, none of this means that you are going to crush the market over the next 3 months or even the next 3 years. Over time, sure, the idea is to get better results than investing in the broad market. Hopefully you can see that you do have a fighting chance.
"People will always try to stop you from doing the right thing if it is unconventional." -Warren Buffett
If you have stayed with me so far, perhaps you see the wisdom in subscribing to this philosophy of investing. But if it’s a good idea, then why do few people actually implement it?
Much has been made about how the deck is stacked against retail investors in today's market. There have been many academic studies that show individuals are overconfident, trade too much, and as a result systematically underperform the market. But since we are worried about investing, and not short-term trading, some of that talk can be irrelevant to us. On the flip side, other studies have shown that individual, long-term investors may actually be able to achieve excess returns!
In any case, as it stands today, the mainstream advice given by personal finance gurus and fellow Financial Advisors is something like this sentiment, as told by Nick Magguili:
From my own experience, it seems like there may be another kind of career risk at play at times, I will call it “reputation risk.” This is the risk that a financial professional will be looked down upon by his peers. This could affect your reputation, your ability to get another job, or the ability to generate a high multiple on the sale of your RIA. It’s much easier to be wrong when you are wrong with the crowd.
As a result, conformity within the financial services profession seems to be an issue that we need to deal with. If any of my CFP® peers read this, (and I hope they do), I know there will be a portion of them that will think I am wrong and reckless. That is too bad, (but the reputation that matters most is the one that I have with my own clients at Simple Wealth Planning).
Lastly, I would be remiss if I did emphasize once more that there IS real risk in investing in a more concentrated portfolio of individual stocks. So proceed with care.
Here is where I need to make the distinction between two different types of risk, which are volatility and permanent loss of capital. Volatility is unavoidable when investing in stocks. A concentrated portfolio will probably be more volatile too. Depending on your holdings, if the broad indices decline by 20%, your portfolio could easily decline by 40%. You need to know what you own and be prepared that this could happen.
But I think the risk that an individual investor should be more concerned with is that of permanent loss in capital. After all, there are quality businesses with little debt out there that have a greater margin of safety than the average stock.
Furthermore, the number of holdings that it takes to get a properly diversified portfolio may not be as many as you think. In “Investment Analysis and Portfolio Management,” by Frank Reilly and Keith Brown, the authors concluded that “…about 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks." In other words, if you own around 12 to 18 stocks, you have obtained most of the benefits of diversification, (assuming a portfolio of equal position sizes). It is often said that investors are not diversified enough, but not much attention to the idea that investors may also be overly diversified.
In summary, there are risks to embarking on this strategy, as there are risks in all investing. It’s not for everyone. But if you want to consider it for your portfolio, let’s talk about how to get started.
"Owners make better decisions because it's their money, their company, as compared to executives and professionals, owners, joint companies, to get that dream and make it real." -Carlos Brito, on The Founder’s Field Guide podcast
So you want to become a real investor after all. How do you actually implement a winning strategy? After all, clearly there are many stocks that do not deserve to be owned for 10+ years at a time. Now, the purpose of this post is not to offer a magnum opus on how to pick winning stocks. That’s already been done by the likes of Benjamin Graham, Joel Greenblatt, Peter Lynch, and many more in ways that I could never dream of recreating.
Instead, I’ve distilled from some of the masters the 7 rules we use at Simple Wealth Planning. Here they are:
There is much to be said about all of these rules, but for now I will focus on just the first two.
Owning stocks with owners and operators who have “skin in the game” is my number one rule and the first thing I look for. Think of this way, is there any first principle that demands you should expect to make any profit at all in a stock? I don’t think so, but investing alongside entrepreneurs is a solid reason to think that you might. Because in investing in that business, you become a partner with that owner-operator. You are investing in the very same asset that people who own that business have their net worth in. If they are a good steward of their own wealth, they should be a good steward of yours.
This strategy is no guarantee, but i like it better than investing with corporate hacks with no skin in the game.
Here is investor Matt Houk, who follows a similar strategy, from “100 baggers:”
“I said, ‘OK, Mom, what if Warren Buffett approached you and said he’d manage your money [for a small fee]—would you let him?’ “‘Of course.’ “‘What about Carl Icahn?’ “‘Yes.’ “‘What about Bill Ackman, David Einhorn or the Tisch family at Loews? Would you let them do it for that fee?’ “‘Yes, absolutely.’
This is how you benefit when you own the stocks of capital allocators like Buffett, Ackman, and Einhorn.
There been studies that have confirmed the wisdom of this too. A 2005 report from Henry McVey concluded that this about public family-run companies:
Despite the common perception of public family‐run companies as poor investments, the evidence shows that they actually perform quite well. And there may be some good reasons for this: A family that both owns and controls a company avoids the classic agency problem—the natural tendency of professional managers to pursue some private interests at the expense of their shareholders—that confronts most publicly traded companies. The family's concentrated, long‐term investment in the company and knowledge of the business make them potentially effective and highly motivated monitors.
My second most important rule is to focus on the business and not markets. Consider the results of investors in Pfizer, the pharmaceutical company, during the middle of the 20th century. This stock was profiled in the classic “100-to-1 in the stock market” by Thomas Phelps, written all the way back in 1972. The lessons still ring loudly today.
In the book, Phelps points out that Pfizer, a stock that would go on to produce a return of greater than $100 for every $1 invested, had a chart that looked like this over a 20 year period:
If you were to zoom in on this slightly grainy 1970s chart, you would notice that there were years where the stock price went sideways, down, and often underperformed the broad U.S. stock market. In particular, it didn’t look great from 1946-’49 or 1951-’56. These would have been trying time for investors overly focused on short-term results.
Too bad if they sold, because these investors would have whiffed on one of the great investments of that era.
Phelps’ offers an antidote to this sort of thinking. That is to ignore the stock price and instead focus on the business. When you look at the real business results, like earnings growth, dividend growth, and return on equity, it paints a different picture. Check out this chart, once again from the book:
The stock was volatile, but you will notice that the business results were amazingly consistent. Would any savvy business owner sell a company with results that looked like this? I think not. Then why sell great businesses based solely on their short-term price movements?
You will notice that watching the results of a business is done over years. It is not months, days, or even minutes. The result is that you are no longer frantically glued to your computer screen, desperately trying to make sense of your investments in the “modern markets.” You are thinking of your collection of businesses like a rational human being. And that is a real benefit.
Long-term investing is the more intuitive and understandable approach.
I want to rediscover the craft of investing.
This is the old-school pursuit of growing your wealth slowly and inspiring your generations through common stocks. This strategy is human, intuitive, and contrarian. You could even call it unconventional. But if you can commit to this process as a young man or woman, stick with it for decades, you have much to look forward to in the form of riches and wisdom.
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Andy Flattery is a CERTIFIED FINANCIAL PLANNER™ and Owner of Simple Wealth Planning. He serves young and affluent families that are working to lower their time preference and achieve financial sovereignty. Flattery is the host of The Reformed Financial Advisor Podcast, where he relates stories in Kansas City history to pivotal themes in personal finance. When he’s not helping individuals build wealth, you can catch him playing rec sports, reading Austrian economists, and spending time with his wife and three children.
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