Writer: Steve Dinnen
There are rules to live by. And there are rules to invest by as well, if you want to do so profitably. One of the rules I learned, rather late, came from a friend who listened as I groused about losing 55% of the money I had invested in U.S. Steel. I was just sure it was going to bounce back and even added to my position trying to average down my cost per share.
“Ten percent and out,” he counseled. Once a stock loses 10%, it’s time to sell it. Yes, it may bounce back. But it could just as easily lose that 55%.
Probably two-thirds of my trades are losers. I count on the one-third win side to make my money, and since adopting this rule, I still see two-thirds of my trades as losers, but by limiting the downside on those losers my portfolio value has increased at a better rate.
While my friend’s 10% rule is completely arbitrary, J. Kelly Flynn (pictured) has a more scientific approach to investing, as well he should because he does it for a living for himself and clients at Prospective Value Partners, where he is chief investment officer. Flynn looks at metrics such as ROIC — return on invested capital — “a proxy for quality,” he said. Into this mix he blends weighted average cost of capital, or WACC. And the ROIC needs to exceed WACC. If not, he said, the company is destroying value when it deploys capital.
Flynn also likes a high free cash-flow yield. As an example (he’s not necessarily making a recommendation), Flynn points to Johnson & Johnson (JNJ). It has a market capitalization of around $450 billion, and about $20 billion of annual free cash flow, which gives it a cash flow yield of 4.5%.
“Everything is free cash-flow positive,” he said of the portfolio he manages. “To me, it’s all about growing cash flow over time, whether you’re a value or growth investor.” His portfolio currently has an aggregate FCF yield in excess of 7%.
All this number crunching brings discipline to Flynn’s investments. It’s not all numbers, though, as Flynn frequently talks to management teams and looks at qualitative measurements, such as changes in insider ownership.
Also on the qualitative end of the spectrum come some personal rules John Schmidt, a retired attorney from Principal Financial Group, follows when he’s making investment decisions. These should be easy to follow, right?
- Be fearful when others are greedy and be greedy when others are fearful. This is attributed to Warren Buffet.
- Don’t buy things you do not understand, e.g., cryptocurrencies, hedge funds, options.
- Distinguish between investments (intended to be held more than one year) and securities held for trading purposes, and limit your losses on securities held for trading.
- Be patient. Few people get rich quickly.