When we wrote Triangle Investing we went straight to the point, areas we think will grow long-term and didn’t provide how we got to these conclusions. We explained why we thought they would grow materially over the next several years but didn’t include the “thinking” part of the equation. Since this is more abstract we decided to make a post about it. This will help explain why we take bets such as Trump’s Presidency with high risk of being incorrect along with other bets with high chance of being correct (with lower payouts). There is no “correct” way to invest as long as you’re making money but we felt a solid post on this topic would be useful to help spur on some new ideas. There is no one size fits all and risk is often tied to your age, your net worth and your long-term plans of being worth $1M, $10M or even $1 billion. To emphasize we will be focusing entirely on investments, not a business in this post.
What Is Investment Money: First we need to define investment money. It boggles our mind that people really believe investing can be compared to running a business. It isn’t even close. If you run a profitable business your best ROI is inside that business (99.9% of the time). So when we talk about investment money we define it as follows: money that is sitting around excluding cash needed for emergencies and outside of business activities. This means there are really three chunks of money: 1) your personal emergency money, call it at least 6-9 months of living expenses, 2) the money you need to keep investing in your company/business – new SKUs or ideas, advertising etc. and 3) dead last is investment money. This should make it crystal clear that the only money we’re talking about is money that is in excess of options one and two.
When Should You Care: The second most important thing to remember here is that you need a reason to care. Most people think it’s worth their time to “trade stocks” when they have a net worth of $500K. We simply laugh. Even if you’re a good investor you might be able to outperform the market by 2x consistently. Assuming 7% returns this means you’d make $70K a year versus $35K a year. This is a $35K difference which is absolutely not worth any meaningful amount of time as you’re essentially working for minimum wage. Now when you start to get to $1 million plus in investable assets, the game changes quite a bit. Using the same math, $140K vs. $70K is appealing and $70K is something worth paying attention to. Even then it still doesn’t deserve all of your attention since your business returns will be in the 50-100% range anyway. So. With that cut off in mind, this is why we recommend simply dollar cost averaging into index funds like the S&P 500 until you reach $1M in investable assets. At that point you can take a look at the rest of this post.
Niche Investing: Contrary to popular financial advice, we’d argue you will find better stocks to buy or sell if you focus on the industry in which your business operates. If you are an expert in cosmetics, you will probably have an edge when it comes to investing in cosmetic companies. You’ll know which fads are dying, growing and the general health of the main players in the space. At this point you should have this level of niche knowledge. We already know that markets are not efficient near-term so you will likely find these pockets of opportunity. It must be emphasized. The second reason we think this is the best way to start is because you don’t have to invest a lot more time into learning about the industry. It’s part of your day to day work anyway so you’re essentially “double dipping” on niche knowledge. Sure makes a lot more sense than learning a random unrelated sector such as gambling and starting from scratch.
Risk vs. Reward: At this point you’re now balancing risk and reward between ideas you come up with. We have a strange approach. We use “probabilistic investing” to come up with our ideas. It means that we assign probabilities to the event happening and then create a payout chart. There is no way to “teach” this since that’s the entire skill in the first place. If you can teach someone it’ll lose its value anyway. Hence the value of niche knowledge. We can use our prior history of betting to explain what appear to be contradictory bets: Trump and Floyd Mayweather. We’ll use a gambling example since its easy to explain when the odds are printed on a computer screen.
Trump: This was a low probability play. The odds around bet time were 6:1 payout. We won’t go through the exact math, but this essentially says he had a 16% chance of winning (1/6, again this isn’t exact we’re just doing it for visual purposes). Now, at the time he hadn’t even won the Republican party so if you believed that he would win that, his odds would move to around 3/1 or 2/1… which is exactly where they went. We’ll stop there for a second. If we look at that it means we thought he had a much better than 16% chance of winning at the time of betting. We thought he had a 40% shot at the time since we were quite convinced on his Republican party win based on Artificial Intelligence data on Facebook at the time. Essentially, making a bet on Social Media overtaking the value of mainstream media… which would eventually prove true. As a final item, since our bet was based on a 40% ratio, if our normal “bet amount” was $1,000 (it is much higher), we would bet $400. This isn’t exact science but that’s the rough math.
Floyd Mayweather: This was a high probability play. The odds of him getting a knock out paid 95%, meaning if you bet $100 you won $95. Essentially saying that betting on the fight not going the distance was a coin flip. We almost ruined a pair of shoes jumping up and down in excitement. The best boxer in the world was going to fight a guy who wouldn’t even beat a top 500 boxer in the world. Our best estimate of the fight not going the distance was around 97% and of a Floyd Mayweather win it was 99.5% (the 0.5% being accidental DQ or other unforeseen event). Naturally, this required a full bet size on both items since he also had 1/5.5 odds on winning in the first place (seriously people thought he only had a 81.5% chance of winning…). This led to a very large monetary gain.
Others: We won’t go through the other wagers we made (Canelo, NBA MVP, Ted Cruz, NBA Finals, and several others), we used the exact same formula outlined above. The one thing we would add is that we will never give our formula away. Just like anyone who actually has something that works, the won’t give it away for free unless it doesn’t work (hello forex and penny stock scammers!). The good news is we’ll continue to announce bets that we think are easy wins relative to the odds on the screen.
Begin to Tie it Together: Notice, we don’t bet consistently and we don’t bet on things we are clueless on. We only bet on ones we deem to be obvious and have good niche knowledge. You won’t see any baseball bets from us any time soon since we don’t watch it. The same goes for hockey and several other activities we never watch and would require immense amounts of time to learn about. Better to just focus on what you know and assign probabilities to it.
Secret Sauce – Emotion: The other thing you’ll notice about the wagers above along with our stock investments is that there must be an emotional angle. If there is no emotional angle it is harder to create spreads in a market. If everyone agrees then the numbers are terrible, just look at the payout for the Golden State Warriors winning their division, it pays something like 1:9,000. Just not worth the time. You want something where there is a lot of emotion and a big following so the “fans” and “die hards” can lose their money to you. This is one of the reasons we consistently choose basketball, boxing and politics. Everyone gets “fired up” over politics and other things that don’t matter like a guy throwing a ball through a hoop… But. That is the opportunity! You need these die hard fans to mess up the odds and give “hope” that you can then take advantage of. Nothing better than the crowd that roots for the underdog particularly if the underdog has no chance at all (I.E. Floyd and McGregor). Now we’ve given away the second step! Not only do you need niche knowledge but ideally you also have an emotional angle as well. That’s where the bigger returns show up (relative to risk).
Beating the S&P: Since we have no idea where your knowledge base is, we use the S&P 500 as the rough benchmark. Instead of worrying about the performance of the S&P 500 all you should worry about is overall US economic growth. If overall growth is stable at say 3% and earnings grow a bit faster than that, call it 6-7%, that usually leads to around 7-10% stock price growth for the whole S&P 500. This is also not exact math and we don’t think it’s worth the time to go through the nitty gritty of every single company and its growth drivers. Keep it Simple.
If this is the “basic case” all you’re looking for is something that will grow faster than the S&P 500 with a *valuation* similar to the S&P 500 today. There is the arbitrage. If you see a Company with the exact same sales multiple and P/E multiple as the S&P 500 but it is going to out grow the average S&P revenue and earnings… you found something worth your time. If the prior sentence is correct, it means the market does not believe that the Company will outgrow the S&P 500 and does not believe the margins and earnings profile will be superior. If you’re near certain (you better be if you invest) that this won’t be the case, then you should be buying the Company since the stock should do better than the S&P 500 on better numbers each year.
Now the Nitty Gritty: While we could write a 1,000 page book on this topic alone we’ll just do the highlights so you can come up with your own procedure. Since no company is exactly like the S&P, here are the major questions to ask yourself before you click buy: 1) will revenue growth truly outpace the average S&P 500 company over the next 5-10 years, 2) is the business model less risky when compared to the average S&P 500, 3) if it is more or less risky, ask yourself if this deserves a discount or premium – risky would be fad like products or items that may be disinter-mediated in the future, 4) if the revenue line looks good, then ask yourself if the gross margin and operating margin line is better or worse than the average S&P 500 company, will the margins get better or worse, 5) take a good look at the balance sheet and ask yourself if it is better or worse than your standard S&P 500 company, overly levered companies should trade at discounts, 6) ask yourself if any income statement line item would change near-term, this could be a positive like tax reform or it could be a negative like the cost of the product going up due to suppliers increasing prices, 7) take a look at the competitive position and ask if there are high or low barriers to entry, 8) check for basic accounting errors to make sure the cash flow statement looks legitimate and does not have red flags that suggest fraud, 9) look at the overall market and ask yourself what would make the entire market, not just the company you’re looking at, grow faster or slower and put a stated deviation or probability on that and 10) to cap it all off ask yourself who is running the Company since he or she is going to determine a lot of the execution success or failure along with the ability to raise funds.
What a disaster of a paragraph! As you can see it’s only a start and it looks like a ton of work. This is yet another reason why the rich get richer. They are experts in a field due to running a business in the same field. Then they can answer around 7 of the 10 questions above without doing any work… Then they simply solve the last few items and invest wisely without having to waste a ton of their immensely valuable time. If you’re serious about investing… all of this should really put the nail in the coffin. Unless you’re already worth a good amount of money ($1M plus in investable assets), your time is better spent trying to get rich on something else versus individual securities analysis. When “your lucky friend” makes a 20% return one year on a stock with a whopping $40K position, you can simply congratulate him but realize he wasted his time (10% outperformance is $4K offset by all the work needed to research the security).
Don’t Blow Up: This is a good mantra to keep in mind. If you’re starting out with your $1M portfolio, your first rule of thumb is to avoid leverage. This means you won’t be buying call options, put options or levering up to buy/short securities. It just isn’t worth it relative to the risk. We know, we know. This limits returns. But. It also keeps you sane since you’re avoiding large losses. Leverage should be used for homes since it is a lot easier to know if you’re in a rising or falling interest rate environment and a lot easier to mitigate the risk of leverage in a real estate portfolio. Naturally, the prior sentence is a mix of truth and opinion. And. It’s also a lot easier to manage. The main reason why is you can “force” the home to get better rental yields with upgrades while it’s not possible to “force” a publicly traded company to suddenly turn the business around (unless you’re a baller activist investor with a ton of money!). So. This is the basic mantra for an investment starter pack. No leverage. Leverage is for things you can partially control at minimum.
Be Honest: The last item is transparency. A significant number of people will still fail to outperform the market even with niche knowledge and a successful profitable and growing business. This is easy to mitigate. You simply create two accounts. One account will always dollar cost average into the S&P 500 index and the second account will be the investment account. Every 2-3 years you can then get the annualized returns by comparing the two separate accounts. You can always try to do this under one account since you can see the S&P 500 position, but, we’ve found separate accounts is easier. It’s easier since you can look at when you contributed new money. It’s a lot easier to track with separate accounts as sporadic investments of say $5-10K in a month is easy to forget over a multi-year period. In an ideal world you’ll find that you’re outperforming nicely over time. Even if this is true we still recommend having a slug of money in the dollar cost average approach (call it 30% minimum of total stock portfolio).
To put some numbers around it, if you’re going to follow this high level advice, your first portfolio should be ~$250K active account and $750K passive account. If you outperform over time, you’re going to move more and more money into the active account such that the active account goes from 25% of the total stock exposure component to 35-40%, 50% and eventually 60-70%. Even if you’re really doing well, we wouldn’t go much past 70% since you’re going to be working really hard on the real cash flow machine (your company!).
Wrapping it Up: If we look at the over arching themes, we see the following big highlights: 1) investing won’t make you rich and 2) most people spend way too much time on it when they could be doing something else. People still whine and cry about “career” income but the math never works. Sorry, those “$500K a year gross income per year careers (after you’re already in your mid 30s by the way) only pay out $300K or so on a post tax basis. The reality is that it won’t get you into that $10M level without a ton of luck on your side. The reality is… you *need* ownership. You need ownership fast and perhaps the one way to do it in a career is by going into a massively growing tech company… if and only if you get a notable slug of equity. If you’re happy being rich when it’s too late to enjoy it (60+) then avoid doing the math in excel and focus on growing that “lucrative” career.
Naturally we want to end on a positive note which is as follows: you can generate good returns if you’re smart. This can be gambling, it could be investing and it could be real estate. It could be all three (our strategy). The key is to remain disciplined and avoid investing into items you’re unaware of. Build up the knowledge base, capitalize on human emotion and keep yourself honest in the process. It’s a fun video game. After all, once you get good at the real video game of life (anything that makes money) it becomes more entertaining than any other hobby you have had in the past. Dollars are just “rank points” in this fun game of life. They aren’t worth much in the end unless you spend them so be sure to do that as well.