Eliminate Fear From Your Investing… Forever

 Ryan's Big Secret… The One He Will Work Hard To Teach His Kids

This is Ryan's  Daily Journal, a free e-letter from Porter & Co. that provides unfiltered insights on markets, the economy, and life to help readers become better investors. It includes weekday editions and two weekend editions… and is free to all subscribers.

Later this week, Porter will launch one of the most audacious investment projects of his decades-long career. What he says could potentially create more wealth for his readers than anything he’s ever done before. For more details about his million-dollar mission – and how you can be a part of it – click here.

Eliminate fear from your investing – forever… Selling stocks short is a great way to reduce risk in your portfolio… The biggest secret to investing… The No. 1 thing I’ll teach my kids about stocks… What I’m going to buy this year…

Even though the markets are closed today in honor of Memorial Day, we bring you something Porter shared with readers more than a decade ago.

This excerpt from his first Stansberry Digest of 2014 covers a range of topics… some that we have just recently begun to focus on at Porter & Co. – trading. And others that are at the core of our investing strategy. 

For years, Ryan;s  musings in the Friday edition of the Ryan's Digest were essential reading… and this was one of his best.

Here’s Porter in January 2014…

For 15 years now, I have been working hard to give individual investors the strategies, information, and insight they need to compete with the pros on Wall Street. A lot of the most important things I’ve published appeared here in the Friday Digest.

As we start 2014, I want to rededicate myself to serving you. And in that effort, I’m going to try to do something I shouldn’t… I’m going to give you the one, big secret. It’s the only real, true secret of finance. And once you understand it, you won’t need us (or anyone else) ever again.

As longtime readers must be tired of hearing me say… I write the Friday Digest personally because I feel a huge responsibility to tell you what I would want to know if our roles were reversed. You’ve paid us to help you make decisions about investing your hard-earned savings. We aren’t fiduciaries. We don’t offer any personalized investment advice, nor do we manage anyone’s money. But this doesn’t absolve us of responsibility to you. You deserve our best. And since I launched this business in 1999, I’ve always tried my best to live up to that obligation.

Over the years, I’ve explained a lot of Wall Street’s “secrets” – like how to manage risk, for example. And why “junk” bonds (high-yield corporate bonds) are sometimes vastly better investments than stocks. (For proof of that, just look at the returns we earned recommending Rite Aid bonds to investors back in February 2008. I’m certain that’s more money than most people will ever make owning a stock.)

Likewise, we’ve covered why selling naked puts is almost always safer and more profitable than buying stocks outright – something I’d wager your broker would never explain.

Even more contrarian is our opinion that selling stocks short is a great way to reduce risk in your portfolio. Just go back and see how this strategy protected us in the bear markets of 2002 and 2008. Our recommended portfolios were up huge by shorting shares of Lehman Brothers, Fannie Mae, Freddie Mac, and Capital One – enough to offset almost all of our other losses.

And then, there are the basics we’ve covered dozens of times – like how important it is to be able to value a security before you buy it. The nominal price of a stock or the nominal coupon of a bond is completely useless as an indicator of value. If you don’t understand exactly why this is so, please… do yourself a favor… don’t own any securities. You should never own anything you don’t understand.

These concepts – discounted bonds, shorting stocks, valuation, trailing stop losses, and selling puts – are critical to active investors. They all play a role in giving you the tools you need to increase your returns. You ought to know all about them and be able to use them tactically to take advantage of opportunities in the market. I’ve written about these concepts many times over the years. And I’ve probably said they’re the “most important” thing I could teach you from time to time. I wasn’t lying. All of these strategies have their “time in the sun.”

Remember in late 2008 when I urged subscribers to begin selling puts. It was the best tactical opportunity I’d ever seen. I promised that we’d make at least 50% on every trade – and we did! At the time, the CBOE Volatility Index (VIX) was at an all-time high. The VIX measures the premiums people are paying on options that protect the value of their stocks. So it’s a good measure of fear in the stock market…

The VIX spent much of late 2008 at well over 50 and occasionally surpassed 80… indicating a huge amount of investor fear. I knew it was the greatest opportunity of my entire life to sell risk, and I urged you to do the same. At the time, it was the most important thing I could tell you.

The same was true at certain points in 2009 when the yields on junk bonds were 22 percentage points greater than the yields on similar-duration U.S. Treasury debt – the greatest risk spread of my lifetime. Here again, explaining why you had to buy bonds then was, at the time, the most important thing I could tell you.

Believe me… having this tool bag and knowing when to use these strategies will make you a much better investor. It will allow you to profit from opportunities the market always creates. 

(Editor’s Note: We will be exploring these topics in  which we are launching this Friday. To learn how to become part of it, click here.)

So what’s the one thing I’m going to teach my kids beyond the obvious stuff about saving, compounding, and risk management? What do I believe is the real secret to investment success? And… the biggest question of all… How do I invest my own money in securities?

Over the long sweep of your investing lifetime, strategies that only work extremely well in certain market situations are unlikely to play a dominant role. The big secret therefore is something you can use all of the time, for your entire life, as an investor. And here it is: Some companies are much better than others at compounding capital. Much better.

If your goal as an investor is to compound your savings over time, wouldn’t it be easier to simply figure out which companies will compound your capital at an acceptable rate, buy those firms (and only those firms) at reasonable prices, and then do something else with the rest of your time?

Here’s a simple, but powerful example. Well-run insurance companies can produce what’s called an “underwriting profit.” They are literally paid money in advance to manage your capital. And they get to keep not only the investment profits, but profits from the premiums, too. That’s like paying the bank to keep and use your money. No other business can compound capital so consistently.

Insurance companies have other fantastic advantages, too. They’re able to legally defer most of their taxes. They’re nearly immune from economic factors. They’re scalable. I could go on. They’re a focus for us because well-run insurance companies are legendary compounders of capital. Buy them at a reasonable price, and it’s impossible not to do well.

In the March 2012 issue of Ryan’s Investment Advisory, we explained that insurance stocks had rarely been cheaper. We recommended several throughout the year. Since then, stocks of all stripes have exploded higher… but they haven’t outpaced insurance companies. Insurance stocks as a whole – as measured by the SPDR S&P Insurance Fund (KIE) – have far outpaced the S&P 500.

It’s not an accident that the greatest investor in history, Warren Buffett, has long focused on insurance stocks and other companies that are highly capital efficient. That is, companies that are natural wealth-compounders. Starting with his 1972 investment in See’s Candies, Buffett gradually over the years shifted the bulk of his wealth into a simple, long-term compounding strategy…

While Buffett didn’t abandon all other forms of investing, his largest allocations since 1972 have all used this compounding strategy. That famously includes his 1988 purchase of Coca-Cola (KO)… when Buffett put roughly 25% of Berkshire’s capital into a single stock! And it wasn’t a cheap stock, either. At the time, Coke was trading for 16x its annual earnings. Buffett had figured out the one, real secret of finance… the one secret to “rule them all.”

To use a long-term, compounding strategy effectively, you really only have to answer three questions. First, is the company in question able to produce very high returns on its assets? In other words, is it a great business? Second, are these unusually high returns very likely to continue for decades, without requiring large and ongoing capital investments? Third, can the management of the company be trusted? Will bankruptcy never be even a remote possibility? If the answer to these questions is “yes,” then all you have to do is simply not pay too much when you buy the stock.

Most of the companies that fit these criteria are branded consumer-products companies – stocks like McDonald’s (MCD), Coke (KO), and The Hershey Company (HSY). Buffett explained in his 1983 shareholder letter how he thinks about these companies. The secret to their long-term earnings power is very simple: It’s their brand and the relatively unchanging nature of their products. These companies’ products are so well-known (and adored) by customers that these firms can constantly raise prices to keep pace with inflation.

Meanwhile, the brands – while requiring some advertising – aren’t like factories, gold mines, or drugs. They don’t require massive investments of new capital. There’s no new gold mine to find and build. There’s no patent that’s going to expire. And there’s not even any new product that must be created: Coke’s fans went crazy with anger when the company tried to change its product in a small way back in 1985.

All these firms have to do is continue to deliver the same thing, year after year. And that means they can afford to return huge amounts of capital to shareholders. Merely buying and holding any of the stocks I mentioned above would have made you 15% a year annually if you’d just reinvested the dividends for the last 30 years. Even if all you did was invest $10,000 and then nothing else – not a penny more – you’d still end up with $575,000 at the end of 30 years. If you invested $10,000 annually, you’d end up with $4.3 million.

And the best part? This approach can be used by anyone. The math is simple. And is it really that hard to realize that Heinz is the best sauce company… that Coke is the leading soft-drink business… or that McDonald’s makes the best hamburgers?

The number-one objection I get from readers when I talk about this strategy is: “That’s great, Porter. Wish I’d known about that when I was 25. But it’s too late for me now. I don’t have 30 years.”

That’s nonsense. Think about it this way… Buffett was born in 1930. He didn’t buy Coke until 1987. He was 57 years old. It has been one of the greatest investments of his life – bar none.

If that doesn’t convince you, just think about it this way. How often do you make more than 15% on your portfolio in a year? Whether you’ve got three decades to invest or only one, you should aim to produce the highest possible annual return without putting your capital at undue risk. There’s not a safer investment approach than this one, as your returns are being manufactured by great businesses. You don’t need a “greater fool” to pay too much for your shares to make a profit. In fact… The biggest risk you face is selling at all because that will trigger taxes (in most accounts).

I’ve written entire issues of my newsletter about this strategy. I’ve recommended several stocks using this approach.

These companies all produce something akin to financial antigravity: They earn more and more money, year after year. But most investors will never see it. It’s this seemingly invisible power that allows them to return massive amounts of capital to shareholders, a factor that sets them apart and greatly reduces investor reliance on capital gains. This is incredibly important over the long term.

To show you a bit more about how this works and how different these companies are compared with “regular” companies, let’s take a look at one of the companies that made our list last year. To make this interesting… let’s take a look at one of the least likely companies to ever end up on a list of capital efficient businesses – Heartland Express (HTLD), a trucking company.

What? How could a trucking company – with the huge capital investment required to maintain a fleet of trucks and trailers – end up in a list of capital-efficient stocks? How could a transportation company – supplying what’s essentially a commodity – be a great business?

Incredibly, this company earns 10% a year on its asset base, produces returns on equity of 20% annually, and carries zero debt. If you read Heartland’s latest letter to investors, you will see why almost immediately – exceptional management.

Heartland is the most efficient trucking company in America by a huge margin. Its operating ratio (operating expenses as a percentage of gross revenue) is the lowest in the industry. As a result, its profit margins are the biggest: Heartland has earned a 12% net margin over the last five years. The company earns more than a dime on every dollar of revenue. Swift Trucking, a larger trucking company picked at random for comparative purposes, earned about 2.5 pennies on each dollar of revenue in 2012.

The difference in profitability means everything. Swift, unlike Heartland, can’t generate enough cash to afford its massive annual investments in trucks and trailers. So it has to borrow. It currently holds $1.3 billion in debt, requiring more than $100 million a year in interest payments. That makes a huge difference in a competitive business like trucking.

There’s also no money left over for shareholders. Over the last three years, Swift hasn’t returned a penny to shareholders. And instead of buying stock, the company has been issuing it – more than $800 million worth. It’s as if, rather than working for the shareholders, the employees and management of Swift expect the shareholders to support them.

At Heartland, everything is different because of the focus on operational excellence. The company is producing more than $100 million a year in cash. It’s no secret how it does it. The CEO explains: “We distinguish ourselves by operating a new fleet of well-maintained equipment, industry-leading driver pay, and outstanding federal Compliance-Safety-Accountability scores.”

Heartland is constantly the highest-rated trucking firm in the country. It was 2013 FedEx carrier of the year with 99.8% on-time delivery. Again, the CEO explains exactly how they do it: “The achievement of our goals can only be attained through the hiring and retention of the best drivers in the industry.”

Management seems willing to spend heavily on the things that matter and nothing on anything else. And that’s the company’s key competitive advantage.

There’s a fascinating correlation – one that won’t surprise you – between great business operators (like the guys at Heartland) and companies that are focused on creating shareholder value. Management owns 47% of the common stock. Its interests are aligned with yours, as the shareholder. Over the last five years, Heartland has paid $441 million in cash dividends. And it has purchased more than 12 million shares of stock ($180 million), reducing the shares outstanding by 12.6%.

Thus, merely by receiving the capital returned to you by the company itself, you would have earned about 40% in five years. Price appreciation (capital gains) is all “gravy.” But there was plenty of that, too… Since December 2012, when Heartland first appeared on our list of capital-efficient companies, its shares have gone up around 50%.

Heartland’s returns dwarf the returns available to shareholders in other trucking companies. And here’s the crazy part: Until a recent spike in Heartland’s share price, investors could have bought the company for $13 per share (it’s now almost $20) – and at a price-to-earnings (P/E) ratio far lower than Swift’s. In short, the market rarely recognizes the value of the differences between companies that I’m explaining here. And that’s your edge. This knowledge gives investors who understand capital efficiency an almost unbeatable advantage.

Please understand… I’m not suggesting that you would want to buy Heartland now and hold it for the next three decades – especially not at its current price. Managerial excellence is difficult to depend on over long periods of time. Like Buffett explains, you should prefer to own a business that’s easier to manage – that could be run “by monkeys.”

I’m only using Heartland as an example to show you how these often-overlooked differences in a company’s operations can make a huge difference in the returns available to shareholders over time.

If you can learn to beat the S&P 500 over time with a trucking stock by focusing on capital efficiency, then by focusing on businesses with higher gross margins and less capital requirements, you can do even better.

Follow insurance stocks, for example… or consumer-products companies. Follow industries that have small capital requirements.

That’s the big secret… the one I will work hard to teach my children… and the secret that guides my personal investing. Each year, I try to find one high-quality, supremely capital efficient company to buy and hold forever. I can diversify this portfolio over time, adding only one stock each year. This will allow me to manage risk without having to sacrifice quality.

I believe this is the safest way to earn 15% or more on my portfolio, year after year. If you will adopt this strategy for at least a portion of your savings, it is overwhelmingly likely that you will succeed, too – assuming you refuse to pay too much for the stocks you buy.

Here’s the best part. If a significant portion of your wealth is invested this way, you never have to worry about what the market is going to do. Take me, for instance. I’m sure to make good profits, year after year, no matter what happens to the stock market simply because of the cash being generated by the companies I own.

I value the stocks I own the same way I value my own company – by the amount of cash it generates for its owners every year. I couldn’t care less about the market price, as long as I know that the company continues to gush cash from operations and as long as I can trust the managers. With that out of the way – with all of my fear removed – I can concentrate on capitalizing on the opportunities created by the market’s volatility.

Most investors will never have this advantage. And therefore… they will never be able to use the other profitable tools we also write about.

The lesson is simple: Take care of the basics first. Make sure your money is compounding at an acceptable rate. Once that’s covered, you’ll be in position to invest very successfully using other tactics.