In this episode of the Market Call Show, we're discussing mastering long-term investing and balancing risk and return through strategies like adjusting asset allocation over time.
With large-cap sell offs recently, we highlight opportunities in small-cap stocks and look at the fundamental analysis of these businesses.
Drawing my experience as a portfolio manager, I'll share some of the tools I've used, like quantitative analysis that can help safeguard your hard-earned capital before uncovering economic sectors with untapped potential, such as property and casualty insurance.
Wrapping up, we dive into way you can optimize outcomes by staying grounded in market turbulence, making increment adjustments, and embracing diversification across sectors and investment styles for stability.
SHOW HIGHLIGHTS
- I discuss the importance of long-term compounding and protecting investments during market volatility, advocating for a balance between steadier and more volatile investments in portfolios.
- We talk about recent market trends indicate an overvaluation of large-cap companies, suggesting that small caps may offer promising opportunities for investors.
- Emphasizing the significance of risk management, I draw on insights from my book, The Financial Freedom Blueprint, to highlight the necessity of sound economic principles and fundamental analysis.
- Investment expert Jim Rogers is cited, stressing that no single asset class is perfect and that a thorough risk assessment is essential for aligning investment goals with risk tolerance.
- I explore the strategic investment approach within the property and casualty insurance sector, recommending a blend of active and passive strategies for a diversified, all-weather portfolio.
- The importance of probabilistic thinking and incremental strategy adjustments is highlighted as a means to navigate the financial landscape successfully.
- Small-cap companies are identified as having rising potential, with quantitative analysis being a useful tool for building well-balanced portfolios.
- Fundamental metrics and scoring methodologies are recommended for better investment decision-making, rather than relying solely on indexing.
- I stress the need for a steady pace in investing, focusing on long-term fundamentals rather than reacting to market volatility.
PLUS: Whenever you're ready... here are three ways I can help you prepare for retirement:
1. Listen to the Market Call Show Podcast or Watch on Youtube
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3. Work with me one-on-one
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TRANSCRIPT
(AI transcript provided as supporting material and may contain errors)
So part of the idea of long-term compounding is having investments that have more steadiness to them over the long term. Or, if you have investments that are more volatile, to have them sized in a way to their impact, so their impact is smaller to the portfolio.
Intro Sequence
Welcome to the Market Call Show where we discuss investing wisely and living well. Tune in every Thursday to Apple Podcasts, spotify, google Play or subscribe on YouTube.
Louis
Louis Llanes. Here I am going to be discussing and riffing on something that I haven't talked about in a while, and that's protecting your money. Today I was looking at the market and we saw a pretty good sell-off one of the worst sell-offs we've seen in quite a while and actually what's happening is to be expected. It's something that I've been talking about. I've been talking about how the valuation of the larger cap companies many of the companies that have been the darlings have really gotten out of whack, really, and we're starting to see a correction. I was talking to a friend of mine and I was telling him about how I saw small caps being a relatively good opportunity. I think there's a lot of skepticism out there sometimes when you have these big locations in the market, and it's understandable, because it's easier to follow the crowd. Following the crowd is something that we naturally have an instinct to do, especially when it comes to investing. One of the worst things that we ever want to do is to be in a situation where we feel like we're missing out or kind of the phone feelings that we can have that really create a feeling of angst when we see certain investments going up One of the things that's interesting about the investment world, at least in the public markets, is that you see marking up and increases in values happening slowly, and then, whenever you have a correction, it tends to be quicker and some people feel surprised by that. So, as a long-term investor who is focused on the economics of investments for the long run, based on cash flows, we can have periods of time where there's a dislocation or there's a disconnect between what we're seeing in the markets and what sound fundamental analysis would indicate you should be doing, and during those times it can be very challenging for investors because it's very easy to make decisions that are not based upon the long term. And in fact, many times, as a professional investment manager, we feel pressure, and I feel pressure from clients who are saying wow, maybe you're out of touch or maybe you don't understand what's happening. Maybe you're out of touch or maybe you don't understand what's happening, and you have to explain that these things are not one to one, but over time.
Good, sound investing requires for you to compound over time and to think rational, long term, and I think we're in a position right now where many investors have just been indexing, which is something I've been talking about, kind of ad nauseum indexing, which is something I've been talking about, kind of ad nauseum, and whenever you have a situation where indexing seems to be the best and only thing to do, inevitably it is not the best thing to do in my opinion. Now, I have nothing against indexing. I think indexing has its place and should be part of a strategy. But, on the other hand, if you want to have above average rate of returns or if you want to have returns that on a risk adjusted basis that can weather a lot of different environments, it's better to have a fundamental approach where you're really looking at the economics and the cash flow to the economics and the cash flow. So I wanted to talk a little bit about stuff that's been on my desk and how it relates to, I think, what many high net worth investors are dealing with right now in terms of just making decisions for capital that are coming in from various sources and being in a position to protect your money.
So in my book, the Financial Freedom Blueprint, in chapter four, I wrote a chapter called Protecting your Money and one of the things I say on there and I just kind of quoted Benjamin Graham who says Wall Street has a few prudent principles. The trouble is that they are always forgotten when they are most needed. That is probably one of the reminders I think that we need right now is what's most needed right now in terms of a principle is that the value of an investment is the present value of its future cash flows over time, and if you get too far away from that, then you will tend to have problems, and we've lost sight of that, I think, as investors you know because of for many different reasons. So, in the world of finance, risk management separates the winners from the losers, and it's more important to really, now more than ever, that you select your investments based on the fundamentals, and risk management requires you to have rules to size your investments. So I'm going to talk a little bit about sizing investments for high net worth investors and what that means to you, and thinking about your positioning. The most important thing is that your exits when you exit an investment or reduce your positions, your exits when you exit investment or reduce your positions and when you actually are attempted to break rules how to get your mind in a position where you can really work for the long run and be focused on the long run and redirecting your attention, and you know, we all want to say that we're rational, we all want to believe that we are rational creatures, but we really are emotional creatures, no matter who you are. So the biggest challenge is to stay rational.
One of the ways that you can look at risk is volatility, which is just basically how much movement up and down various investments have. That is a it's a useful way of thinking about risk when you're coming from a fundamental standpoint. It's really not the risk that is the most important. The most important risk would be the chance of losing money based on the difference between where the market is pricing an investment now versus where its intrinsic value is its underlying value based on cash flows. The problem with the concept of intrinsic value is it's not a science, it's not something that you know with 100% certainty, so it's really something that you have to estimate within range and within reasonableness. So it's really more about reasoning, and when you have something that is obvious, or more obvious, that there's a difference between price and value, that's when you should be concerned, and so that's one of the things that I wanted to talk out.
So the question is does buy and hold make sense? Well, I think buy and hold does make sense as long as you're owning investments where the quality is such that there's a strong competitive advantage. So for most importantly with stocks. So if you have a company that has a strong competitive advantage with their competitors high return on capital then obviously that buy and hold is a good thing to do. It can get ahead of itself and be above intrinsic value and maybe you wanna not invest as much future capital into it. And then times when they come down in value those high quality investments that have good competitor advantage then you want to add to those and it takes discipline to do that.
So one of the things that a gentleman by the name of Jim Rogers you may have heard of him. He used to work for George Soros. He worked in the George Soros' fund as an analyst. He was a very solid analyst. He said do not buy the hype from Wall Street and the press that stocks always go up. There are long periods of time when stocks do nothing and other investments are better.
So there is no perfect asset class. I had a conversation with another friend of mine who really likes real estate and I always say that when I'm talking to her because I hear about how great real estate is, and I'm just thinking about all the times that certain real estate projects can be problematic and so there is no perfect asset class. It goes down to valuation. So protecting your resources, I think, is really important right now. Making up a loss that is big, it's harder to recoup because percentage losses you have to gain more on a percent basis to make up a certain loss. So, for example, if you're down 50% on an investment, then you have to go up 100% just to break even. So part of the idea of long-term compounding is having investments that have more steadiness to them over the long term. Or, if you have investments that are more volatile, to have them sized in a way to their impact, so their impact is smaller to the portfolio.
So in my book, one of the things that I say is that there's a few risk principles that I found to be very true. Number one is never take more risk than your finances can withstand. And the second rule is never to take more risk than you cannot psychologically endure. In other words, if you're going to capitulate when an investment is not doing well because you've taken an investment that you psychologically whatever your makeup is you just can't deal with it, then you're gonna surely lose money because you'll sell out at the wrong time. And my third rule is always to match your goals to your risk tolerance. In other words, whatever goal that you've set for yourself, make sure that it incorporates what your risk tolerance really is and match that.
So when I look at a risk profile, it's kind of like a triangle, where at the top of the triangle there's your tolerance for risk that's really psychology and then on one side you have your risk requirements. So you might have a minimum amount of risk that you have to take in order to get a return that you need to make, and that's something that is just about rock bottom minimum risk that you must take. And a lot of people sometimes get in a situation where the minimum risk that they need to take in order to achieve a certain return you know they're not unwilling to take. And what I mean by the risk in this context is just short-term movements, temporary movements. You know you have to be able to think long-term in terms of that. And then you on the other side of this triangle is risk capacity, and that is kind of the maximum risk that your finances can actually withstand. So you know, having some kind of a sense about those three things can really help you when you're exploring your risk profile and protecting your capital.
So step one is to perform a risk assessment really and look at what kind of risk profile you really truly have. And once you've done that, your risk capacity rule is never to take more risks than your finances can withstand. And then your risk tolerance rule number two is to never take more risks than your finances can withstand. And then your risk tolerance rule number two is to never take more risks than you could psychologically endure, which I had talked about. And then your risk requirement mismatch rule is if your risk tolerance is lower than your risk requirement, you should consider adjusting your goals to be more realistic. So once you've kind of assessed your risk, then I really think about really determining your key metrics that you want to look at in terms of risk.
And for me as an investor, when I'm thinking long term, I'm thinking about the types of investments that I want to hold that are likely to have the risk characteristics that I'm willing to hold on to and in order to achieve a good return. And to me, a good return is where you're able to return above the inflation rate and you're able to be compensated for the amount of risk that you're taking, but also to have more of an understanding about the economics of the business, makes sense, and so when all of those things are together, well then you can feel more comfortable in what you're doing. So there's all sorts of statistical things that you could do with risk analysis if you will, and there's all sorts of programs that people will show and all that, but when you really look at it from a long-term perspective, you cannot untie the economics of the underlying investment cash flows. You can't untie that from your risk profile. Really. That's really how it's really related to so when you construct portfolios.
And so why am I talking about all this stuff? Mainly because I think we have lost sight of the long-term fundamental analysis and we're starting to see that correction happen, where investments are moving into more industrial companies, into some of the tech companies that are more solid, or some of the companies that are in other financial industries that make some sense, even international companies. We're starting to see that happening. So it all boils down to the economics of these investments. So I was just thinking about how that ties into various stock strategies. So one of the things we do for high net worth clients is we invest in a wide variety of investments, but in the smaller cap realm that has been of more interest lately because of the valuations and there are a lot of small companies that are not making profits right now, so you have to avoid those. So buying the small cap indexes are not quite as attractive then as being selective, in my opinion, and that's really basically always the case. But in particular, there's a lot of opportunity in smaller companies.
One of the things that I do is I do quantitative analysis, where, through powerful software packages, we could look at the various ways to construct portfolios using fundamental analysis and we can look at a lot of different factors and look at different ways and simulate different portfolio strategies to see the impact on portfolio results. And one of the things that we see consistently is when you apply fundamental metrics on more inefficient areas in the market, like smaller and mid-cap companies, you tend to have outsized returns. You tend to have returns over the longer term that are better than buying kind of the tried and true that everybody knows and so you know over the long run. That is something to keep in mind and in fact, if you want to have outsized returns, I think it's really important to be able to not always be looking where everybody else is looking. You have to be looking in places where they're not, where most people are not looking, and I was just looking at various factors in the smaller cap area that have been doing well.
I always take a lot of notes when I'm doing these things and because my goal is for our clients to compound over time and not to stick our neck out right, there's always movement in stocks, but when you look at the factors that make the most sense, one of the things that always comes up has to do with earnings. Basically, you know what are earnings doing and you know. One of the areas that I like to look at because it really, you know, historically has contributed a lot to returns is what's happening with the revisions of earnings. So companies that are tending to do better right now the earnings are being revised upwards, and so we have ways that we can actually scorecard and do what's called factor analysis and look at ways to actually identify companies where their earnings are being revised up and also that we're seeing that there's a surprise in the earnings. So the earnings were expected to be, say, $1 a share, but they're coming at $1.20 a share. That would be an upward surprise. But they're coming at $1.20 a share. That would be an upward surprise. A revision would be the analysts are saying, okay, well, we thought they were going to earn $1, but now we think they're going to earn $1.20. So they're starting to move them up.
So those factors can help as well. As the variation in the earnings estimates is a valuable indicator. So if too many analysts are all over the map, somebody thinks a company is going to earn a dollar a share, no one thinks it's going to earn 10 cents a share and there's a lot of variation. You know that is actually, should be, actually. You should actually, I guess, handicap for that if there's a lot of variation there. So somebody's calling me right now, so I'm not going to answer it obviously, because I'm doing a podcast right now. So those factors tend to have a lot of value when you're looking at developing strategies.
And another, it just has to do with the quality of companies, you know, and there's various angles that you can look at. One angle you can look at would have to do with the profitability of a company. You know. Are their gross margins strong compared to their assets? Are their gross margins strong compared to their peers? Are your capital efficiency ratios strong? In other words, for every dollar of capital that we invest in this company, that the company invests, how much revenue or profits are they able to generate? So if it's a highly capital intensive company, you know you'd want to handicap that company versus another company. So having high capital efficiency, high profit margins and then having those a solid growth plan or growth profile like I had mentioned, the revisions and the upgrades and the low variability and estimates things like that that tends to help companies. In particular, if you compare how companies that have these characteristics do with larger companies compared to smaller companies, there is a spread historically that you've seen between the performance of these types of investments. So you know how many positions you own and how you construct a portfolio is a huge part of your success as well. But it all starts out with what are you going to invest in.
So one of the things that I like to look at are companies that have this competitive advantage that we talk about and you know it's kind of a cliche, but it is a very real, important part of stock investing and company investing. But the idea of competitive advantages is are they earning above average returns on capital compared to their peers? Do they have some moat around their business that is going to allow them to maintain that? Or there's some preferential client or customer preference that is allowing them to keep that? Or do they have some other barrier to entry or something like that that's going to keep their margins solid? No company has an infinite competitive advantage.
But recently I've been thinking about companies in the property and casualty insurance. They're able to raise their prices in an environment like now and it's been a very good investment as of late, and there's times when people just kind of forget about them, but then you know they all of a sudden. It's like wow, okay, yeah, these are. That's a great business, you know being in the property and casualty insurance business, but anyhow. So the reason why I'm bringing this up is because when you're focused on these types of factors and not just indexing per se, I think you have an advantage and if you have a definite way, one of the things I like to do is to have a kind of a ranking or scoring methodology based on these factors, and the more attractive these factors are the more you invest in a particular investment are the more you invest in a particular investment. And there's various ways that you could do this.
But having more investment in those more attractive companies and making your weights more related to the fundamentals, in other words, having more or less based on the fundamentals, you know, allocating more or less capital based on that versus just a market cap weight. Just, you know, market cap weight is very efficient because it's kind of the collective wisdom of the entire marketplace moving the relative weights. And that's one of the beautiful things about indexing. And whenever you have a very rip roaring bull market, it's very difficult to beat an index mathematically, just because of the efficiency of the way it's calculated. So I have no problem with that. There's a time and place for that, I think, when you have more challenging times.
Being selective is more important and you can in my way of investing, and what I usually recommend as a reasonable way to think about it is to have an active component to your investment strategy as well as a passive component, but not to get overly enamored with passive investing or active investing. If you're going to err on being over enamored, I think it's better to be overly enamored with diversification and strategy. Diversification in a way that is kind of all weather, so that you can invest across various styles. So you know it's interesting because when I was thinking about another conversation I was having with a client and you know there are always many people want to have this definite kind of view. They want you to have a definite view about a specific outcome and I think probabilistic thinking is hard for some people. But I think that is the right way to think about investing and saying it's like handicapping, it's like handicapping horses or if you're into handicapping football teams or baseball players, it's the same kind of concept. It's like money ball. So you basically are working at the probabilities and when you have something that is a fat pitch and that really makes a lot of sense right now, it's important to really allocate priced for perfection right now.
But getting back to these factors, and the reason why I'm bringing this up again is because this is about protecting capital and one of the ways you can protect capital is not by being super defensive with all of your money and throwing it all under the mattress, but you want to keep your money compounding right and accept the fact that you're going to have variability in investments. It's really important because if ever, if you always want to lower your variability right after something has gone down, you're definitely going to be losing and you're not going to do as well as you should. But having more of a steady pace and then to think, make your investment decisions not based upon the vicissitudes of up and down, but more about the fundamentals, then you wind up doing a lot better. And sometimes it doesn't feel good when you're doing that, because there's a difference between what everybody is saying in the media versus what you have to do as a solid investor for the long run. So, as I'm looking at these various strategies, the thing I wanted to bring up was the smaller companies tends to do well. So, as I'm looking at these various strategies, the thing I wanted to bring up was the smaller companies tends to do well.
So many investors are all in the same stuff. They're in the NVIDIAs of the world and all that, and maybe not enough in some of the smaller names that make more economic sense. And then also many people are in large companies that don't have enough competitive advantage. These companies, maybe they're on a tear right now, but they have no competitive advantage. There's other entrants that are coming in, and it's a commoditized business. It's just a business that right now is doing well for some reason, but it's likely to be cyclical and to likely not do well in an economic downturn. And so many.
I think it's important to emphasize more large, larger, medium-sized companies that have a wide boat around their business that you can take reasonable investments in rather than just owning the indexes. And then the other thing I would point out is that there's other investments that are really not related in the fixed income market I think that you can take advantage of, and having some dry powder does make some sense. And just because when you're making these strategy adjustments, it's good to do things incrementally, not to just make massive, drastic changes. So obviously it depends on where you are, but if you are in a situation where you know maybe you just need to do some tweaking to the portfolio so that you could have a better outcome in the long run, and I've been telling people that right now it's time for us to you know, financial planning is important, but right now is a good time to be thinking just about your investments. Get down, roll up your sleeves and get in deep with the investments, not just kind of precursory. You know this. Here's my little pie chart and I'm going to have this.
No, I'm saying what makes economic sense and think bottom up and think diversification and think about, not defense. You want to be on offense all the time but you want to manage the risk as you play offense in a market really always because the key is to keep money compounded, because it's very difficult for you to time a bottom and one of the biggest parts of the returns happen after you've had a drop. The acceleration after a drop is usually much higher than as you're kind of easing your way up and most people miss out on those accelerations because they are trying to time things or they get too aggressive after a move has already been up. So we've had a big move in the equity markets recently, and it wasn't that long ago when we had a little bit of a downdraft and there was nervousness everywhere.
So my challenge for investors today is to stay level-headed and stay focused on allocating your capital based on the economics of what's going on with your investments, and staying with that and not being really about it and thinking more like Benjamin Graham talks about Mr Market. Mr Market is sometimes going to be your friend and it's going to hand you an investment on a platter with a great price and it's a good company. And then other times, and usually when everybody is super excited, mr Mark is going to be over exuberant and be just bidding up stocks and you should be trimming back from those companies and putting them into other things. And that's really the message that I have today, and I really think it's a timely message because, you know, based on not only today's market action but the fact that we've been seeing these trends, you know getting fairly frothy for a while, so it's time to really get back to basics, and so I guess that would be really the title of this presentation here, this podcast, is to get back to basics and to make economic rational decisions for your allocation of capital and not be in a position where you're chasing anything.
All right, that's it for today. I'm in Texas right now and I'll be here for a while just wrapping up some things here, but be back in Denver soon. This is Louis Llanes signing out for the Market Call Show and we'll talk to you later, take care.
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