My 70 Rules for Stock Investing: Part One

I’ve achieved a 15% compound annual return in my personal stock investing portfolio over my 12-year investment career

Robin Speziale | May 29, 2017 | SmallCapPower: I’ve been investing in stocks since I was 18. I started in my dorm room at the University of Waterloo in first year (2005) and haven’t stopped investing in the stock market since. It’s been a passion of mine but also a path that I feel confident enough in to build wealth over time. I’ve achieved a 15% compound annual return in my personal stock investing portfolio over my 12-year investment career. You can read more about my investing background here.

But what I haven’t gone into depth sharing is how I invest in stocks. My thoughts on the market, which types of stocks I pick, and why. My journey in writing the best-selling book, Market Masters, was certainly an inflection point for me. By meeting with, and learning about top investors’ investing strategies, and their frameworks, I upgraded my own investment approach. Experience also played a crucial role, having invested through the financial crisis (’08), two bear markets, and a handful of corrections. So, while it’s not all perfectly structured, with lots of rough notes, I’ve outlined below My 70 Rules on Investing in Stocks. These rules will give you access to my investment thought process.

Related: 25 Stock Market Beating Canadian Stocks

For the budding investor, these 70 rules will hopefully be valuable information to help get you started in the stock market. And for the experienced investor, maybe there’s something new that you didn’t think about before, or at least that my rules validate how you’re already investing in the market.  Enjoy.

My 70 Rules on Investing in Stocks:

1. I’ll only hold 25-40 core stocks in my portfolio, because at that point I’m well-diversified, and am not diluting my portfolio with ‘so-so’ picks. I have high conviction in my current holdings. Plus, I can more easily follow 25-40 stocks on a quarterly basis than I can 40+ stocks. Any number above that and it becomes a circus.
2. I don’t let any stock grow larger than 10% of my portfolio. That opens me up to potential risk. My winners will approach 10% position size as they grow, so I take profit off the table, and allocate those funds to my new emerging opportunities.
3. I only invest in companies where I can confidently project future cash flows. I can’t confidently project cash flows for companies in cyclical industries like mining, financial services, and pharmaceuticals, etc. I find it funny when I see shiny models that project 10 years of cash flow in unpredictable businesses. That’s like putting lipstick on a pig. And an ill-fated attempt at fortune-telling.
4. Similarly, I don’t invest in “price-takers,” like oil & gas companies that have to price what they sell based on prevailing crude oil market prices, for example, but rather invest in “price-setters,” that can raise prices year-after-year to generate higher revenues. Plus, it’s virtually impossible to fudge top-line revenue figures through financial engineering, like it can be done with net income / profit.
5. There’s only two ways a company can continually increase revenue over time: by raising prices or increasing volume (whether that’s through increasing the number of customers, average transaction size, or transactions per customer). I invest in companies that can achieve both price and volume growth. Also, revenue needs to be sustainable and recurring over time. I don’t like lumpy, and inconsistent ‘one-off’ revenue. To illustrate, I find it amazing that a ‘dollar’ store – Dollarama – can do both; increase its store count (volume) and its prices (higher than a dollar!). That’s why I’m a happy Dollarama Inc. (TSX: DOL) shareholder.
6. I really like companies that can expand globally. Think about a company’s product’/services’ addressable market. The growth potential is enormous when the addressable market is virtually everyone in the world. That’s why companies that can become near-monopolies, with little-to-no competition, like Google (NASDAQ: GOOGL), are ideal investments, especially at early stages in their business life cycle.
7. The companies that I invest in need to have a competitive advantage, whether that’s through their operating model, distribution network, brands, niche products/services, patents, technology, regulatory protection, goodwill etc. I ask, “How hard would it be for a competitor to take any of their business?” And, “Can technology or innovation disrupt this business model?” I also employ Porter’s 5 Forces to validate a company’s competitive advantage.
8. Cost cutting isn’t a business strategy. Companies that cost-cut to generate profit, and appease the Street for however long, aren’t worth my time. You can only cut costs so much until there’s really nothing great that remains. I want revenue growth. Companies that are growing are hiring, investing, and spending.
9. I don’t invest in any industries or traditional businesses that are going bust. Newspapers, anyone? And as of late, department-size brick and mortar stores. The best case study is the Blockbuster-to-Netflix wealth transfer. That’s why I always invest in relatively new businesses and avoid mature business models. I want to invest in the wealth-recipients, like Netflix in this example.
10. Companies should be earning high rates of return on capital (ROIC), generally around 15%, (and at a minimum above their cost of capital) consistently over at least 5 years, and preferably over 10 years. I don’t rely on Return on Equity (ROE) as a measure as it can be distorted with big debt loads. And lots of debt can sink companies.
11. What happens at the company level needs to also occur at the per share level. For example, growth in net income translating into an increase in earnings per share (EPS). Along those same lines, I want to see an increase in book value per share, and free cash flow per share, over time. Some management dilute their existing shareholders through mass expansion of shares outstanding, in other words; using their shares as currency.
12. I focus my picks in the more inefficient small-cap and mid-cap segments. Those are the smaller-market-capitalization companies ($100 million to $10 billion) that can double, triple, quadruple, and more on the stock market. If I owned large cap companies ($10 billion +), I’d just be replicating the index and its performance, and so could save myself time by just buying an Index Fund / ETF.
13. When there’s a systemic market decline; recession (e.g. financial crisis ’08), bear market (e.g. TSX 2015), or the common correction, I’ll invest more money into my existing stock holdings. Remember, the world isn’t actually going to end. I’ll happily buy great companies at cheaper prices. But when an individual stock drops in price, among a normal-range  market, I think long and hard before investing more money, i.e. dollar cost averaging, because…
14. Managing a portfolio is like gardening. Instead of watering my weeds, I water my dandelions, so that they can grow bigger. In other words, I reward my existing holdings (the “winners”) by increasing my stake in them when they post great earnings results quarter after quarter. I like to see 15%+ EPS growth. And I also like a beautiful garden.
15. Underperforming, cheap stocks (those “weeds”), can get cheaper, and cheaper, and cheaper. And they’re probably getting cheaper for a reason. That’s called a value trap. And I don’t like getting trapped. Not all stocks ‘bounce back’ as some investors hope (and pray!). I am always happy to pay a little more to invest in quality companies. And that’s fine by me because I’m buying a company’s future cash flows, not just what it’s worth today.
16. The companies that I invest in don’t have a lot of long term debt on their balance sheets. Preferably, no debt at all. Overall, tightly controlled and clean balance sheets.
17. Free cash flow is king. Companies that generate high amounts of free cash flow, combined with good capital allocation, can grow at high rates through reinvestment in the business, smart acquisitions, and opportune share buybacks, especially if shares are cancelled annually for a prolonged period of time. Plus, lots of cash means companies can self-fund, not having to heavily rely on the debt or equity markets, even through economic down-cycles when credit dries up. Exceptional free cash flow generators are usually those companies that require less capital expenditure to run their business. High cap-ex intense companies are sluggish, requiring too much capital to grow, and even then, deliver low returns.
18. The free cash flow / enterprise value ratio (FCF/EV) might be one of the best, but overlooked metrics, one can use to identify exceptional capital compounder stocks. That combined with high return on capital (ROIC) to demonstrate effective allocation of free cash flow.
19. Buy and hold “forever” doesn’t work. Sure, Warren Buffett says that his favourite holding period is “forever,” but what he says isn’t always what he does. Recent case in point: IBM. I understand that businesses don’t last forever. There’s life and death. It’s basic high school business class curriculum, where we learned that businesses go through several stages: Seed, Start-up, Growth, Established, Expansion, Mature, and then Exit. Look at the Dow Jones, S&P 500, and other major indices over history. Companies come and go. I make money when I can, from “Growth” through “Expansion,” and don’t hold onto a dying company.
20. I always strive to maintain around a 15% compound annual return in my portfolio. If one of my stock holdings isn’t keeping up with the pace, I’ll sell and allocate those funds into a company that can generate higher returns. I’m always thinking about opportunity cost; where money can work the hardest for me. Generally, a company’s compound returns are correlated to its return on capital (ROIC) over time. That’s why the stock holdings in my portfolio average 15% return on capital. Because I want to achieve a 15% compound annual return. It’s important to note that I find any compound return over 15% isn’t sustainable in the long-run. I would be taking on too much risk to achieve that hurdle.
21. I never invest in stocks just because they have high dividend yields. Most of my holdings have low or no dividend yields, where capital is used in more effective ways (e.g. re-investment into the business). High dividend yields are indicative of large-caps, mature businesses, and in some cases, businesses in decline.
22. I buy “growth at a reasonable price,” meaning that I won’t buy a stock with a 25 P/E and 10% EPS growth rate, but will buy a stock with a 30 P/E and 30%+ EPS growth rate. It’s all about the growth.
23. I’m not a value investor. I don’t buy obscure “net-nets” aka deep value stocks that I know nothing about, hoping that the market will see what I see, and then finally bid up the price of the stock in line with its underlying net-asset value. That could take months, years…never.
24. I need to understand the businesses in my portfolio. That means that most of my stocks (80% +) fall into these 3 industries: consumer franchise, technology, and diversified industrials. Some people want to look ‘smart’ by buying into complex industries like bio-tech. But I like boring, and unsexy companies that generate high return on capital on a consistent basis. Bonus if they’re leaders in their respective industries. Some of my best investments of all time are in companies that I spotted in the mall, supermarket, or just out and about; the products and services that people buy on a recurring basis. I don’t invest in the stock market to look smart. I do it to make money.
25. Before I initiate a new position, I don’t first think, “How much money can I make?”, Instead, I ask myself, “How much money can I lose?” I consider all the ways a stock can lose money before I even think about the upside.
26. I accept that I’ll have losers in my career. Some stocks will decline, and not work out. But it’s my job to make sure that my winners always outnumber and outperform my losers. I just have to swallow my pride. Because investing can be a probability game even after countless hours of fundamental research. That said, as I progress in my investing career, my losers aren’t a result of investing in companies outside of my circle of competence (e.g. biotech), but rather placing too much faith in management that doesn’t deliver on its vision, and growth projections.
27. The stock market has buyers and sellers. I want to make sure that when it’s time to sell my stock in the future, that there’s a buyer who wants to purchase it from me. That “high-level,” simplistic thinking has saved me from bad transactions. Similarly, I don’t want to be the sucker buying a bad deal on the other end; for example, a mature/declining business at the peak of its cycle. I want to buy a company that has just entered its growth phase, where it’s worked out the kinks in its business model, and simply needs to replicate its successful formula.
28. The majority of my bigger, core positions are in mid-cap companies that continually earn high return on capital (ROIC), generate free cash flow, and grow their earnings and book value per share, through their expansion phase. But I’ll also plant seeds in smaller companies that have yet to fully prove themselves. And unlike my core holdings, some “seeds” aren’t even generating a profit (net income). I’ll invest more money as those companies’ plans do play out, but quickly trim when they don’t. And to hedge against a bet in a very small company, I’ll ask myself, “Is this company an acquisition target; does it have assets that a much larger company wants?” Sometimes the returns from those small-caps are mostly from just getting bought-out by a larger company. As a general rule, when I do invest in small-caps, there should be as much ‘optionality’ (e.g. takeover potential, and other factors, etc.) as possible.
29. I never want to lose 50% on any stock. I know when to cut my losses before I lose too much capital. A 50% loss requires a 100% gain to revert back-to-even, and then “getting-even” is exponentially harder the more money one loses. I don’t want to dig myself into a hole and then struggle to get back out.
30. I’m wary of “blue chips.” They’re never a sure-thing in the stock market. I can list lots of once “blue chip” companies that don’t exist today or are at least shells of once large companies. They’re not as “defensive” as one would think. Mature businesses are ripe for disruption. As an aside, one day after work (this was 2006, and I was 18), I was riding the go-train home (Lakeshore West), and started talking with the “ambassador” – the guy who announces the stops on the intercom. After some small-talk, and upon him learning that I’ve just started investing in the stock market, he tells me, “Son (he was around 65 years old), I’ve done really well in Citigroup, Bank of America, and Yellow Pages. Buy blue chip companies that pay a dividend, and you’ll do just fine.” I didn’t buy any of those so called “blue chips” in 2006…
31. I’d get a bit cautious once ‘normal-average-everyday’ people, who’ve never bought stocks in their lives, are getting into the stock market because of a certain hot sector, or hot stock. Especially when they proclaim, “It can only go up” and “It’s so easy to make money right now,” without conducting any fundamental research. That’ll probably be a good sign that a peak is forming in the market (actually, reminds me of the Toronto housing market). But I also realize that markets can stay euphoric for far longer than I think. Regardless, I don’t cash out. I stick with great companies as long as they’re great. I don’t just sell when I think my stocks have become overvalued (unless they’ve crossed my 10% portfolio size threshold), or when the market is reaching its “peak.” Some people might never buy stocks because they’re always “too expensive,” and then miss out on every bull rally until they die.
32. I know and accept that I’m not going to get rich quick. I control my greed. Because greed can lead to very bad decisions in the market. I don’t feel ‘smart’ when my stocks have gone up in a bull market. Because a rising tide lifts all boats. Conversely, I invest more in the market when I feel fearful, because that’s when most people are selling stocks, and driving down stock prices, so that they’re cheaper for more astute, and experienced investors.
33. I research small-cap and mid-cap companies as much as I can. And I read as much on the markets as possible. Everyday. I can truly have an informational edge in these oft-overlooked smaller-cap companies, with little-to-no institutional or analyst coverage. For the most part, everything is already priced into those liquid, well-known large cap companies. There’s no opportunity for me to generate alpha there.
34. I don’t care about any macro-economic trends. I don’t follow trends. I just invest in great non-cyclical companies that sell products in good and bad times.
35. When I pull up a company’s metrics on a 10-year table (I use Morningstar.com), I’ll know if I’ve found something special when the business is growing at a consistently high rate over time, and especially if it’s posted little downside during a recession. That’s important; I always check to see how a business performs through a recession.

Stay tuned for Part 2!

Disclosure: Neither any of the principals at Small Cap Power, nor their family members, own shares in any of the companies mentioned above.

The Content contained on this page (including any facts, views, opinions, recommendations, description of, or references to, products or securities) made available by SmallCapPower/Ubika Research is for information purposes only and is not tailored to the needs or circumstances of any particular person. Any mention of a particular security is merely a general discussion of the merits and risks associated there with and is not to be used or construed as an offer to sell, a solicitation of an offer to buy, or an endorsement, recommendation, or sponsorship of any entity or security by SmallCapPower/Ubika Research. To read more of this Disclaimer please click on the button below:

DISCLAIMER