Forever growth?

Growth stocks have been crushing value stocks over the last several years, by:

• 6.3% year-to-date
• 7.1% over the last year
• 3.8% annually over the last 3 years
• 5.5% per annum over the last 5 years

Such a strong run leads many investors to question if growth has formed a permanent advantage over value.  

Briefly, the answer is no.

Over the short to intermediate term, it's quite normal for growth or value to out-perform for a time. But, these periods always end. Just looking back over the last 10 years, value beat growth by 1.1% annualized (even including the last 5 years of dramatic out-performance of growth over value). Over the last 80 years, the data are even more compelling: value has out-performed by over 3% a year.

What gives? Basically, investors tend to herd. They run in one direction for a while, take that too far, and then reverse direction. Value, after under-performing for 5 years, goes on to crush growth for the next 5 years. And then, following that, growth goes on to crush value for the next 5 years. Rinse and repeat. (It's not always 5 years at a time--sometimes it's 1.5 years, sometime 3, 5, 7, or even 10.)

Just like night follows day, growth and value go in and out of favor only to see that reversed time and again. Smart investors look to benefit from this regression to the mean by examining 20 years of results instead of the last 3 or 5 years. You can't time the reversals, so don't try.  Instead, bet on the long-run winning hand, and over time you'll do very well.

You can well imagine that Apple's outstanding growth and performance has greatly contributed to the excellent run of growth stocks over the last decade. Apple now accounts for 4% of U.S. Gross Domestic Product (GDP) and 4.4% of the value of the S&P 500.  

Even if Apple starts producing oil, cars, food, and all the other things in the economy (highly unlikely), its growth will eventually regress to the 3% growth of the underlying economy. When that happens, and it's likely sooner than most think, Apple's growth stock tailwind will turn into a headwind, and value will come back into favor.

I have no idea when this will happen, but I do know growth's out-performance will end and value's out-performance will re-emerge. In the meantime, I've positioned myself to benefit from long-run, time-tested investing wisdom instead of trying to play the short-run, unreliable trends of the moment. Over time, that is the winning hand.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Investing: 3 part harmony

Investment returns seem mysterious to most. You buy one investment and it takes off; you buy another and it tanks; you buy a third and it goes nowhere. Why? It seems more random and unpredictable than the weather at times.  

The underlying reality is more simple than that, though.  Investment returns can be broken into three parts and analyzed individually. Understanding that three part harmony makes investing seems much less mysterious and more practical--and so it is.

Investment returns consist of:

1. dividends relative to price paid
2. underlying earnings growth
3. change in the multiple to underlying earnings

The dividend seems like the most straightforward part of investing returns, but many people seem to overlook the importance of it. What matters is the dividend relative to the price paid over the full period of investment. If that dividend is eliminated (like banks in 2009), shrinks (Real Estate Investment Trusts) or grows (Johnson and Johnson), that can have a big impact on your return. It's important to understand the dividend yield as well as the sustainability of that dividend (whether it will grow or shrink).

The second element, earnings growth, is (in my experience) the hardest to predict, and has  the second largest impact on returns. If earnings grow while you hold an investment, then you have a nice tailwind that can allow you to generate good results (Apple). If earnings shrink (Best Buy), or even tank (Citigroup), it probably won't matter what price you paid or dividend yield you start with, your investment results are likely to be unsatisfactory.  

Earnings consist of underlying sales and profit margins (or book value and return on equity in the case of banks, insurance companies, etc.). If sales grow and margins are stable (Wal-Mart), then earning will most likely grow. If margins grow and sales are stable (IBM), you'll likely experience earnings growth. If margins and sales tank because technology has become obsolete (Blackberry, anyone?), earnings shrinkage will be a big headwind to your results.

The third element, change in multiple to earnings, is the most difficult for people to grasp and is likely to have the biggest impact on return. The multiple people are willing to pay for earnings, which is frequently expressed as price to earnings ($10 per share stock price, $1 per share in earnings, 10x price to earnings multiple), is a reflection of how market participants think of a company and its future prospects. If people think very highly of a company (Amazon), they may be willing to pay 20x or more on earnings; if they think poorly of a company and its prospects (Xerox), they may be willing to pay only 5x earnings.

Market sentiment towards companies changes a lot over time. When people become despondent with a company, it can trade very low to fundamentals; when people become euphoric, a company can trade at very high multiples. Whereas one can analyze and predict dividends and earnings based on underlying evidence, multiples are more likely to be a result that must be judged and reacted to rather than predicted. Buying at a low multiple and selling at a high one gives a tremendous tailwind to investing results.

When you put together multiple change, earnings growth and dividend yield over the life of an investment, you have the three parts of investment return. By analyzing those three parts, you can understand why your investments do well or poorly, and then make adjustments to your investment process. The three part harmony of good returns requires a keen understanding and mastery of all three parts.  

Investment results can be clearly understood if you take the time to do so. Such an effort removes the mystery and reveals an understandable system that can be used to produce good results. This may not sound as exciting as shooting from the hip in hopes of a big win, but good results over time create great wealth, and that's as exciting as can be.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

How much money do I need to retire?

One of the most frequent questions I get is: how much money do I need to retire?

This is a much more complicated question to answer than most grasp. It depends on the returns you can get from now until the day you die, and that isn't a number you can look up on Wikipedia. It depends on how much savings you have, and how much you can and will save from now until you retire. It depends on inflation over the rest of your life, how much you withdraw each year in retirement, how long until you retire, how long you (and your spouse) will live after you retire, how much you need to live on each year, what tax rates will be over the rest of your life, what kind of accounts you have your money in (tax deferred: traditional IRA and 401k; pre-taxed: Roth IRA; taxable account, etc.), and so on.  

As you can see in the list above, there are so many unknowns and unknowables that you can't possibly come up with a precise figure. The best you can really do is calculate an estimate. Added to this, so many people make invalid assumptions (including many financial planners, I'm afraid) that they come up with misleading answers. Other people don't even try because they feel overwhelmed by the process or are just trying to get by from day to day.  

Unless you're in bad health and expect to die before you stop working, it's a very good bet you'll need money in retirement, so this is a number you really should think about. The ostrich technique won't work here any more than it does in any other part of life.

With this in mind, I believe there is a simple way to derive an estimate that will succeed. Like all simplifications and rules-of-thumb, it's not fool-proof, but having spent countless hours thinking about it, crunching the numbers, and applying it, I know it works.

My rule of thumb is to multiply the annual amount of money you want live on in retirement by 30. For instance, if you want to live on $100,000 a year in retirement, then you can retire when you've saved up $3,000,000. This estimate works at any age, too, whether 20 or 60 (although it's probably more than you'll need if you're over 70--and that's a high-class "problem" to have).  

A lot of people gasp when they hear my rule, because it's a lot higher than they expect. Most people don't have anywhere near that amount saved, and they feel daunted by a number so beyond where they are or believe they can get.

I'll admit, my "times 30" rule doesn't assume you have a pension, and it also assumes you won't get social security. This may seem like a gross simplification, but if you understand the adequacy of pension and social security funding, you may want to be prepared for that money to be reduced or cut altogether (especially if you're younger than 50). If you believe you'll get your pension/social security, just use my "times 30" rule for the amount you'll need beyond those retirement dollars (if you'll receive $30,000 from social security and need $100,000 a year in retirement, then use 30 times $70,000: $2,100,000).

My "times 30" rule assumes a 3% withdrawal rate. Most assume they can get much better returns and believe they can withdraw more than 3% a year. The empirical evidence is against them--people who withdraw more than 5% a year are likely to run out of money before both spouses die, and people who plan to get 20% returns are living in fantasy-land.  

Most long term tests show that a 4% withdrawal rate provides enough money to last until death. My problem with that plan: it doesn't provide a margin of safety. Just like I'd prefer to drive over bridges that are designed to handle much more than "expected" loads, I want my retirement plan to be able to handle the unexpected, too, and I believe my "times 30" does this. I use the "times 30" rule personally, so I'm eating my own cooking, here.

Another issue is that most people don't really adjust for the destructive impact of inflation.  We don't know what it will be, so we want to be prepared come what may. I think "times 30" does this (along with a retirement plan that protects investments from the ravages of inflation).

Keep in mind, too, your retirement dollar number isn't something you want to under-estimate. Many who retired around the year 2000 thought the stock market would keep going up and ended up having to go back to work after they retired. That's not a very good plan. You'll want more than enough to retire so you don't end up in that situation.

If "times 30" sounds too difficult to reach, here are some things to focus on that will allow you to get there. First, save as much as you can as early as you can. The impact of compounding makes high, early savings worth a lot more money over time. Einstein called called compounding the eighth wonder of the world, and he knew a thing or two about math.

Second, try to get good returns. Other than saving as much as you can as early as you can, your returns will have the next biggest impact on how soon you can retire. This doesn't mean take your retirement dollars to Las Vegas or play the lottery, it means investing intelligently. Either work hard to find someone with investing skill, become an expert investor yourself, or buy low cost index funds and stick with them. Don't try to time the market or switch into and out of funds to get better returns. Make an intelligent plan and stick to it!

Finally, monitor your path and make adjustments as necessary. I review my retirement plan with my wife at least once a year to make sure we're on track. The way to get on track isn't to switch investments every three years, but to increase your savings to make up for any short-falls. If you have more than you'll need, it's probably because the market is over-valued, so don't spend that portion thinking you're ahead. Plus, there's nothing wrong with reaching retirement early, or with more than you'll need.

If you save 30 times the amount you'll need on an annual basis, I believe you can retire right away--whether you're 20, 40, 60, whatever. This rule isn't a cure-all, but it's an excellent aim-point for those who want to reach retirement and then have enough money to enjoy it.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Stick to your knitting

There are many ways to invest, but, what's more important than any particular method you choose to is whether you stick to it.

One fundamental choice is passive or active. Passive investing is investing with the market. This method is agnostic about market value and broadly diversified. It's low cost and tends to beat most active managers, but can go through long periods of poor absolute returns, like we've seen over the last 12 years. If you don't want to search hard for superior investors and can't stand being out-of-step with other people, then passive is probably your best approach.

Be careful, though, not to waffle between passive and active. More important than your choice of passive or active is whether you can and will stick to your choice. Those who switch between passive and active do worse than those who stick to either passive or active.

Active is investing differently than the general market in an attempt to beat market returns. This is very difficult to do, but if you can find a superior money manager, it can make a huge difference in your long term wealth. Once again, you must stick with the approach for it to work, and this will be hard to do when your active manager is out-of-step with the market, under-performing the market, and charging you higher fees than passive investing. Once again, if you switch back and forth between passive and active, you will do worse than either approach.

Within active, there are several approaches, too. There's macro investing: trying to bet on economic trends in the attempt to have exposure to the best sectors or countries. There's market timing: trying to anticipate market sentiment and buy when things go up and sell before they go down. There's growth: trying to buy the fastest growing companies to beat overall market growth. There's value: trying to buy companies selling at the lowest price to underlying fundamentals. Value has the best long term performance, but even it goes long periods of under-performance between bouts of out-performance.  

I'm going to risk sound like a broken record, but it's too important not to emphasize again: it matters less whether you choose value, growth, marketing timing or macro, and more whether you stick to it. Value may out-perform over the long run, but it won't work if you try to do it when it's "working" and try to do the other methods when they're "working." The academic and anecdotal research on this is unequivocal, people who try to switch methods at just the right time grossly under-perform those who stick to one method consistently.

I'm a dyed-in-the-wool value investor, I'll readily admit, because it works better than the other options. To succeed, though, I have to stick to it in good times and bad, not just when it's "working."

If you want good investment results, pick your method and stick to it. Though some work better than others, nothing works as poorly as trying to switch between them.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.