“All the real money in investment will have to be made—as most of it has been in the past— not out of buying and selling but out of owning and holding securities, receiving interests and dividends therein, and benefiting from their long-term increases in value.”
“Price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal.”Ben Graham, The Intelligent Investor (1949 edition)
By John Kingham
Investing is a very broad topic, so I’ll start with some context:
This website will be of interest to you if you’re looking to invest directly in shares for income or growth.
The site is called UK Value Investor so obviously it’s focused on value investing, and defensive value investing in particular.
What is defensive value investing, I hear you ask?
At its simplest, it’s about building a diverse portfolio of quality companies purchased at value for money prices.
Since 2011 I’ve written hundreds of articles about defensive value investing and in 2015 I wrote 300-page book called The Defensive Value Investor.
You don’t have to be a rocket scientist to invest in shares, but there are quite a lot of moving parts so I put this page together as an introductory guide.
I hope you find it useful.
The basics of investing
Before you can start to invest in individual companies you need to know at least a little bit about company accounts, the economy, stockbrokers and so on.
So if you’re relatively new to investing, here’s a list of resources which you might find useful as you begin your journey:
Once you’re familiar with the basics of investing, your next step is to learn about the basics of defensive value investing.
The basics of defensive value investing
Defensive value investing is an approach which you can use to help you build a portfolio if you have the following investment goals:
- High yield: You would like your portfolio’s dividend yield to be higher than the market average (e.g. higher than the FTSE All-Share’s yield)
- High growth: You would like your portfolio’s total return (dividend income plus capital gains) to exceed the market’s total return over the next ten years (performance over one, three and even five years is largely due to luck rather than skill)
- Low risk: You would like your portfolio to be less volatile than the overall market
- Low effort: You don’t want to spend all your time thinking about investing, so you’d like to make at most one or two buy or sell decisions each month
As I’ve already mentioned, defensive value investing is about investing in high quality companies at value for money prices to build a diverse portfolio.
Those three factors of quality, value and diversity are absolutely central to the strategy, so let’s take a closer look at them in turn:
1) Invest in high quality companies
Why is it a good idea to invest in high quality companies?
It sounds like a daft question. After all, why would anyone want to invest in low quality companies?
However, there’s more to it than that. The real answer has something to do with the unpredictability of short-term share price movements versus the predictability of high quality companies over the long-term.
Let’s start with the unpredictability of short-term share price movements.
In the short-term (which in investing is anything less than five years), share price movements are driven by news and news is by definition unpredictable (if you could accurately predict tomorrow’s news then it wouldn’t be news).
This means that short-term share price movements are effectively random.
If you bet on a random game then winning and losing is purely down to luck, and the same applies to short-term stock market bets (unless you happen to run a hedge fund stuffed full of super computers and mathematics PhDs, in which case short-term trading can be very lucrative).
Because short-term share price movements dominate short-term returns, and because short-term share price movements are effectively random, most private investors should focus on long-term investing rather than short-term trading.
And if we’re going to focus on long-term investments, then we need to understand that over the longer-term, returns from a given stock are driven more by the performance of the underlying company than they are by random price fluctuations.
Think of it like this: A company’s share price might randomly go up or down by 20% in any given year, but if it increases its dividend ten-fold over a decade, then it’s highly likely that the share price will also increase markedly over those ten years.
To put it another way, short-term ups and downs tend to cancel each other out, while long-term corporate growth builds on itself, driving the dividend up and up and up, until the market has no choice but to re-rate the shares upwards.
So, most active investors should ignore short-term price fluctuations and instead focus on investing in companies which are very likely to grow significantly over the long-term.
Unfortunately, companies that can reliably grow their value over the long-term are few and far between. That’s because capitalism is brutal; many companies fail very quickly, while most produce an unpredictable mix of good results and bad results. And as we saw with short-term share price movements, unpredictability is not a good basis for sound investment.
However, there are a few high quality businesses in each industry which have durable competitive strengths. Those strengths make it far more likely that their revenues, earnings and dividends can grow, with an acceptable degree of certainty, over the sort of decade-long time frame that most investors should about.
And that is why it’s a good idea for most investors to invest in high quality businesses.
2) Invest at low valuations
So quality matters, but is it the only thing that matters?
The answer is no. Even the highest quality business on Earth isn’t worth an infinite price, so the price you pay is just as important as the quality of the business you’re buying.
If you want to get a decent return from high quality businesses then you’ll need to invest in them when their share prices represent good (and preferably excellent) value for money.
Here’s an example:
Imagine there’s a company which you somehow know for certain will grow its dividend at 5% per year for the next 100 years. If you buy that company when its dividend yield is 1% then, somewhat simplistically, you shouldn’t expect to get more than a 6% annualised return (from a combination of dividend yield plus dividend and share price growth), even if you own it for decades.
If you’d bought the same company with a 6% dividend yield then it would be reasonable to expect (again, somewhat simplistically) annualised returns in the region of 11%, although of course actual returns would vary somewhat.
The point is that the price you pay matters a lot, so combining high quality businesses with low valuations makes a lot of sense.
3) Diversify to reduce risk
Investing in high quality companies at low valuations is a great place to start, but the future is uncertain, industries can be disrupted and no company is guaranteed an eternally bright future.
Given that inevitable uncertainty, most investors should build their portfolio across a broadly diverse group of businesses. This is, of course, the age-old strategy of not putting all your eggs in one basket.
Diversification has three primary dimensions:
1) Diversify across many companies
BHS, Woolworths, Thomas Cook, BlockBuster. These are all well-known and at times highly successful businesses that eventually went bust.
The future of every business is uncertain, regardless of quality, so investing everything in a handful of companies is almost always an extremely risky choice.
Research suggests that spreading a portfolio more or less evenly across 20 companies will get you almost all of the potential benefits of diversification. If you did that then each holding would be roughly 5% of the total portfolio.
How would you feel if one of those holdings went bust tomorrow? Could you take a 5% permanent loss without panic selling the rest of your portfolio? If so then 20 holdings may be enough for you.
Personally I’m slightly more cautious and I tend to hold about 30 companies, with an average position size of 3.3% instead of 5%.
2) Diversify across many industries
Of course, holding 20 (or 30) banks isn’t what I’d call a diversified portfolio, so spreading your investments across a wide range of industries is a good idea too.
Some investors run concentrated portfolios of say 15 holdings, and have each holding from a different sector, e.g. one bank, one supermarket, one recruitment firm and so on.
My portfolio has around 30 holdings, so that approach isn’t practical. Instead, I try not to have more than three companies in any one sector, so overall the portfolio is spread across at least ten sectors, and in practice it’s usually a lot more than that.
3) Diversify across many countries
The final dimension of diversity is geography. Countries go through economic booms and busts, so investing all your money into UK companies, especially if you live and work in the UK too, means you’re taking on a lot of country-specific risk.
If the UK economy collapses you could lose a lot of money in the stock market at the same time as you lose your job, and that would not be pleasant.
Fortunately reducing this risk is relatively easy. The FTSE All-Share is a very international index, so it’s easy to pick a mix of companies with exposure to a wide array of countries, from Europe to the US, Africa, China and everywhere between.
As a general rule I try to keep my portfolio’s UK exposure to less than 50% by revenue, and it would be easy to be even more international than that.
As you can see, while diversification doesn’t have to be complicated, it is perhaps the easiest and best way to reduce your portfolio’s risk.
Defensive value investing in more detail
If you’d like to read a more detailed explanation of this defensive value strategy, here’s a fairly detailed overview:
If you want even more detail then here’s a list of blog posts which cover almost every aspect of the strategy.
1. How to analyse a company’s accounts
- The importance of consistently covered dividends
- How to measure dividend growth and the factors that support it
- How to find quality companies producing consistent and sustainable growth
- Taking account of Return on Capital Employed
- Related update: The hidden debt of lease liabilities
- Related update: Companies with thin profit margins often make bad investments
- The capital cycle is something every investor should be aware of
- Lessons from a highly cyclical investment
- Measuring leverage
- Related update: Factoring in the risk of excessive corporate debt
- The importance of a strong bank balance sheet
- Debt ratios and pension ratios: Connecting the dots between them
- Defensive shares – An unusual way to value them
2. How to analyse a company’s business
- Value traps – 18 Questions to help you avoid them
- 10 Questions every stock picker needs to ask
- Looking for companies with a durable competitive advantage
- The pros and cons of building an investment story