Week 2 - Underlying Principles for the ITR Investment Strategy

GOAL: to introduce you to the theory and tools behind the ITR blog. [If you haven’t already visited our “Mission & Goals” tab, you might want to read those before continuing.]

Tool #1:  Dollar Cost Averaging

How it works:  A fixed dollar amount is invested into a DRIP every month or quarter. The reason this is important is because “dollar cost averaging” ensures that a larger number of shares are purchased during periods when the stock price is depressed. This is counter-intuitive: the price is falling and your investment keeps falling in value. But it is obvious that you can buy more shares than usual at these cheap prices, and (here’s the really important part) the number of shares in your DRIP account determines the size of your quarterly dividend. This dividend is then automatically re-invested: you are using your “pay-out” to buy more shares. During a bear market, it is important to remember that the market slump is exaggerated by negative investor sentiment. The same applies to bull markets: Whatever the fundamental reason is for rising stock prices, the over-enthusiasm of stock traders makes the price go even higher. Market sentiment is said to account for 30% of pricing in the short term but 0% in the long term. A DRIP investor with a $100/month automatic purchase plan will need to possess a strong stomach to keep watching the stock price fall. But her $100/month will purchase an ever-increasing numbers of shares while the market is falling. What appears to be a fool’s errand in the short run becomes a very smart strategy in the long-term.

Tool #2: Compound Interest

How it works: You start the ball rolling by purchasing some shares for your DRIP. After that, dividends are going to be paid on those shares and that money will automatically purchase more shares. Those shares will pay a dividend 3 months later and that money will automatically purchase more shares. In other words, dividends are paid on dividends. This is a mathematical formula for achieving wealth over time. Even if you have to stop contributing your dollars to the DRIP during a period of financial hardship, you will continue to receive dividends and those will be used to buy even more shares. The total return of the S&P 500 Index is a product of price appreciation and dividend re-investment: 40% of the 9.9%/year growth of the S&P 500 Index since 1925 (moneychimp.com) has been due to re-investment of dividends.

Tool #3: Reversion to the Mean

How it works: When you follow the price of a company’s stock over a number of market cycles (2-3) and compare those prices to the earnings posted by the company, what you will find is that the price of the stock will tend to revert to a mean value of approximately 15 times earnings. So when we find a stock that is selling for more than 20 times earnings, we know it’s over-priced. Conversely, when we find a stock that is priced at 10 times earnings, we consider it to be a bargain. What is “the Mean”? It’s approximately 15 times earnings for ALL assets!! As an example: a house is purchased for 10 times its annual rent, making it a reasonable investment. Then later on, someone offers to buy it for 20 times rent-equivalent income. That would be a really good deal since its price is eventually going to drift back to 15 times rent-equivalent income. This “drift” is called reversion to the mean. It is a basic tenant for buying and selling investments, i.e., buy low, sell high (and we didn’t even charge extra for that little gem!). Another example: the US Treasury offers 10% interest on a 30 year bond but later on the Treasury may pay only 5% interest on a new 30 year bond. That would be a good time to sell the first bond. It’s worth a lot more than what you paid for it because it’s still paying 10% interest whereas the prevailing rate is 5%. Our third and final example: You purchased a stock for 10 times earnings and later it appreciates to 20 times earnings. This is a good time to sell because reversion to the mean is eventually going to take this stock’s price back to 15 times earnings (and you don’t want to be holding it when that happens).

Tool #4: Benchmarking

How it works: This gives us a yardstick for comparing different kinds of businesses and allows selection of stocks that meet our value criteria. Our benchmark is the S&P 500 Index; more specifically, we will use the investible form of that index (SPY) that can be bought or sold like a stock. The S&P Index includes the 500 largest publicly traded US companies. It is “capitalization-weighted”, meaning that the contribution of each stock reflects the value of all that company’s stock. The S&P 500 Index is also non-selective, meaning that all 500 of the largest publicly traded companies in the country are included. Other broad-based indexes use different methodologies. The Dow Jones Indexes, for example, are price-weighted (closing prices are totaled at the end of each trading day) and selective (the Managing Editor of The Wall Street Journal picks the stocks): Dow Jones Industrial Index has 30 stocks, Dow Jones Transportation Index has 15 stocks, and Dow Jones Utility Index has 20 stocks; these are combined in the Dow Jones Composite Index (from which we will select the stocks that will comprise the ITR “Growing Perpetuity Index” that will be introduced in an upcoming weekly blog). Dow Jones Indexes are unscientific but nonetheless represent the Gold Standard of Indexing. Why? Well, they’ve been around longer than the S&P indexes (1884 vs. 1926) and their total returns beat comparable S&P indexes. For example, there are 12 companies in the 65-company Dow Jones Composite Index that meet our value criteria vs. fewer than 35 companies in the S&P 500 Index.

BOTTOM LINE: ITR will use value-investing principles to help our readers select stocks for regular purchase in a DRIP account. We also use a buy-and-hold approach that requires discipline and patience. The main criticism, really, is that our approach to investing is like watching paint dry: it’s very boring. So we’ll try to get our readers to think of boring as a synonym for investing, and interesting as a synonym for gambling.


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