The Concept of a Superior Investment

Everyone knows what it means when something is superior to something else.  In this post, I’ll try to explain how I view potential investments in terms of superiority and what a superior investment looks like to me.

Let’s say we’re looking at 3 potential investments: A, B & C.  If B is superior to C then theoretically an investor should choose to invest in B and not C.  But if A is superior to B, then the investor should invest in A and not B.  This is rather simple to understand yet many investors fail to walk through this basic thought process when making an investment – most likely because they get excited about the potential of C and don’t take the time to think if there’s anything similar but superior. 

Now let’s break down what it means to be superior.  When it comes to investing, there are many variables that factor into the equation and different investors will apply a different weight to each based on their investment goals, risk tolerance, etc.  Let’s start with two of the most common variables to consider: expected returns and volatility.  (Quick side note: Academics needed a way to quantify “risk” so they settled on volatility, but I think that’s a very poor definition of risk because there are all sorts of different types of risk for each investment so I just call it what it is – volatility.  Volatility of total portfolio returns is a big risk for investors taking distributions from their portfolio and so it should be managed closely, but otherwise a proper approach to investing can turn volatility into a benefit.)  Back to returns and volatility… a good metric to compare investments is to look at their volatility adjusted returns (or Sharpe ratio).

Over the past 2 years, the S&P 500 has generated a total return of almost 15% including dividends (about 7.25% annualized) while an investment in the 10 year Treasury bond has returned approximately 14%.  So which has been the better investment?  If we only consider return and volatility, I would say the 10-year Treasury has been the better investment because it has posted similar returns but has been far less volatile (a better Sharpe ratio) and is considered a much safer investment.  That’s interesting to see since investors have totally shunned Treasury bonds the past 5 years for the fear that interest rates might go up.  In fact, Treasury bond have pretty much posted a better Sharpe ratio than the S&P 500 since the 1980’s!

A lot of investors have made the claim that stocks are a better investment today than bonds because the dividend yield of the S&P 500 is higher than the yield on the 10 –year Treasury bond.  The theory goes: why buy a 10-year Treasury and lock in a low return for the next decade when I can just hold stocks for the next 10 years AND collect higher annual income.  They’re making a claim that stocks are superior to Treasury bonds based on relative value by looking at the annual yield alone, which I think is utterly ridiculous.  For starters, no one makes an investment decision, ignores it for 10 years and then comes back to see how it did.  To me, this is simply a rationalization to own a lot of stocks today and “hope” that they do well.  Why does an investment have to be held for a specific length of time (i.e. 10 years)?  Why couldn’t an investor own Treasury bonds while they wait for better valuations (you know, since stocks tend to be volatile and often do go down…) and then sell their bonds and buy stocks at lower prices?  Given current valuations and projected returns, I still think Treasury bonds are superior to stocks purely on a prospective return/volatility basis.  Simple mathematics are going to begin to weigh on the returns of both, so I’d take the better of the two evils (less risk) until stock valuations are more attractive. 

Again, that only takes into account return and volatility while ignoring many other important factors.  For retirement focused investors, one of the biggest risks is inflation where it’s vitally important to maintain purchasing power over time.  Historically, the best way to do this is by investing in equities so obviously any investor with a time horizon longer than 10 years should have some stock investments in their portfolio.  The question now becomes how to invest in stocks, or put another way, what is the superior way of investing in stocks in an environment of Fed-induced, inflated valuations? 

I’ve stated many times before in past posts that I believe selecting individual stocks over a broad-based managed fund or index fund is a better way to go for numerous reasons, including expenses, taxes, the ability to invest in only those companies that you feel are superior (good valuations, good business model, etc.) long-term investments.  I have a simple screen which weeds out over 80% of all stocks in the market as “un-investable” simply because management does not run the business in an efficient enough manner to post the types of returns I’m looking for.  So why would I buy a fund that owns a bunch of stocks that I consider to be a poor investment?  A fund is certainly simpler and more convenient to just “buy the market” but my clients don’t pay me to do what’s simple.  They pay me to do what’s right and what’s best for them.  This often means that our portfolios don’t track the market but I would contend that this is a good thing!  With the amount of volatility that stocks have exhibited lately, not to mention all of history (think 2008…), why would an investor want their portfolio to track that?  That sounds pretty average to me and we’re not shooting for average, we’re shooting for superior.

So let’s discuss a real-life example to walk through a few of the variables that I look for and what I consider a superior individual stock investment.  For the past few years, one of the pillars of my client’s investment portfolios has been Ross Stores (ROST), a discount clothing retailer with over 1,250 stores across the US.  Here’s what makes Ross Stores superior in my mind to most other companies right now:

• It’s a distribution business model, not a brand name.  Brands can often fall out of style with fashion trends; distribution is all about selling whatever is in demand from the customer, it doesn’t matter what the brand is.  This means that brands are often higher risk while distribution models are more consistent and “safer” in terms of stable, repetitive cash flow.
• They have over $750 million of cash and only $400 million of debt on the balance sheet (net cash of $350 million) = rock solid balance sheet with the ability to take on debt if some amazing opportunity presented itself.
• The company generated $959 million of Free Cash Flow last year, more than double the amount generated 5 years ago, and the amount continues to trend higher each year as they open additional stores.  Free Cash Flow is the amount of money leftover AFTER the cost of maintaining existing stores and opening new stores.  You can think of it as discretionary income after the bills are paid.
• They return basically all of their annual Free Cash Flow to shareholders in the form of dividends and stock buybacks (a positive yield in addition to growth). 
• There’s nothing flashy about the business so expenses are low and profits are high
• TJX Companies (TJX), which own TJ Maxx, Marshalls and HomeGoods, is the closest competitor and is very similar to Ross Stores.  I have no issues with TJX and find it superior to many other companies as well.  We’ve owned ROST the past few years instead of TJX because I think it’s run a little bit better based on certain metrics and it’s a much smaller company which means they still have more expansion/growth potential.  I would not be surprised to see these two companies merge one day or to see ROST taken over by TJX. 
• I saved perhaps the best for last: they’re a business that has been thriving, and should continue to thrive, in this economic environment.  Real incomes haven’t grown for the middle and lower class in a long time and that’s who shops at Ross Stores.  If middle and lower income citizens are trying to be thrifty and save money, they’ll look for good bargains at discount retailers like Ross.  If the economy weakens and unemployment rises, more people will likely begin shopping at Ross as a way to save money.  Conversely, if the economy improves and incomes actually rise, some people will trade up and start shopping at higher end retailers but I would bet that most of their customers are happy with the deals they get and are likely to spend more at Ross rather than pay more somewhere else.  Ross Stores essentially has a business model that will thrive in any economic scenario moving forward.

The way I see the stock market today is pretty much in three different groups: A, B & C.  “C stocks” are the ones that have been bid up to absurd valuations.  A lot defensive business models (like utilities and consumer staples) are starting to look this way.  “B stocks” are much more reasonably valued and might even look cheap, and therefore are superior to C in terms of long-term return potential, but the problem is that many are cyclicals (think commodities, materials and industrials) and they still face significant economic risks so the pain probably isn’t over.  Lastly, “A stocks” are the rare stocks that I consider very attractive today and are thus superior to B and of course C.   Ross Stores is in that sweet spot.  There are certainly risks that they face, but all in all, it’s an extremely solid investment story that, to me, remains far superior to most other companies today.  I largely try to focus on the superior A stocks, but we also own some B’s too.  B’s haven’t been fun the past 6 months or so but I expect everything to work out well over the long haul given the valuations.

Thanks for following!

-Nick