August has been all about the Pound. The value of sterling has continued its recent downtrend owing to the UK and EUs inability to make any headway in the Brexit negotiations. As the negotiations stretch out and the deadline quickly looms, investors are pricing in a no deal scenario and this has essentially lead to the destruction in value of the pound.
The importance of the Pound can not be underestimated when it comes to investing. Since the Brexit vote, there has been an inverse relationship between sterling and U.K. stocks. As the pound weakens, stocks tend to go up. When the pound strengthens, UK equities tend to go down. This is because a good chunk of UK listed companies (especially FTSE 100 stocks) earn the majority of their revenues abroad. So a weaker Pound boosts the overseas revenues of globally exposed U.K. stocks and inflates earnings.
So if a company makes $100 million dollar of sales in the US as an example, two year ago it would translate to about £70 million – today that same $100mn translates to £77 million, a full 10% increase. So UK companies are able to show solid earnings figures and can also pay a higher dividends as a result of the higher sterling pound earnings. This pushes up stock prices.
But an interesting thing occurred in the middle of August – the relationship between the pound and UK stocks broke. As the pound kept declining, stocks started to decline instead of rise. This may point to the fact that we have reached an important juncture in the global stock narrative. It may be that the currency and the stock market are being pressured by something more foreboding: global risk aversion.
When investors feel risk averse – they don’t want to take risk – they normally clamour out of stocks and put their money in USDs. This may be a bad omen for the stock market. But I am still not yet sure. I don’t think I am smart enough to predict something like this. But I am nonetheless investing with a very conservative mindset. I only want invest in quality companies. I want a good margin of safety when I buy a stock. I want to ensure I buy at a price that will ensure I receive double digit returns over the medium to long term. It is for this reason that I only bought one stock in August.
That stock Is Associated British Food (LON:ABF) – the giant conglomerate food processing and retailing company. I have written about it before (just search ABF in the search bar on the right) so won’t go into details here.
I bought 10 shares in ABF for a price of £24.33 each. This purchase adds £4.135 in dividends to my passive income portfolio. Sure this amount may sound small but it all adds up in the grand scheme of things. In this instance, the minuscule dividends of £4.135 received from the 10 shares has taken my annual dividend income past the £2,500 mark. I will be writing about this soon so keep checking back.
Sure there were other cheap shares to buy but to me they aren’t worth it. I only want to hold quality companies as these are the ones the shine over the long term. Bad companies – those with poor economics – are usually only good for trading and I am not in that game.
Warren Buffet once described good and bad business in a simple easy to understand way.
He said think of businesses as a savings accounts. The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the bad account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns. So I ask, which camp would you rather be in?
In explaining great businesses, Buffet wrote
A truly great business must have an enduring “moat” that protects excellent returns on invested capital.
The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low-cost producer or possessing a powerful world-wide brand is essential for sustained success.
Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.
When describing great businesses, Buffet mentioned a number of characteristics that need to be present. He made references to these characteristics in a number of his letters over the years. Here are some of the best:
- Our acquisition preferences run toward businesses that generate cash, not those that consume it. (1980)
- The best protection against inflation is a great business. Such favored business must have two characteristics: (1) An ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) An ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. (1981)
- One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it. (1983)
- Leadership alone provides no certainties: Witness the shocks some years back at General Motors, IBM and Sears, all of which had enjoyed long periods of seeming invincibility. (1996)
- The really great business is one that earns…high returns, a sustainable competitive advantage and obstacles that make it tough for new companies to enter. (2007)
- “Moats”—a metaphor for the superiorities they possess that make life difficult for their competitors. (2007)
- Long-term competitive advantage in a stable industry is what we seek in a business. (2007)
- The best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow. (2009)
So when investing for the long term, it is best to find business that fit the above description. It is best to buy quality and let the business do the heavy lifting and compound your wealth overtime.
Conversely, it is of utmost importance to avoid the bad businesses. Avoid businesses that erode your welsh over time. Avoid businesses that
- Consumes more cash than it generates.
- Has managers who boast of certainties and invincibility.
- Earns poor return on capital.
- Operates in an industry where it’s easy for new companies to enter and succeed.
- Operates in an unstable industry (maybe due to technological changes, or government regulations)
- Requires consistent infusion of new investment to grow.
- Doesn’t have an ability to increase prices.
- Isn’t able to accommodate large volume increases in business with only minor additional investment of capital.
Save this list. Bookmark this page. The next time you plan on buying a stock, ensure the underlying company is a good one that compounds your wealth instead of a bad one that makes you go broke.