From July 2008 to October 2019, my stock portfolio averaged approximately 18% annual return. (Some years were negative, some were flat and some were positive. Most likely, I will have more negative years in the future.)
But this is not possible if I followed stock prices. I initially based some of my buy and sell decisions on largely stock prices, but I had to learn to base them on mainly business metrics. To beat most investors, you must follow business metrics, such as the company’s revenue and profit.
Warren Buffett wrote about the best investors in the world. His list includes Charlie Munger, who became his partner at Berkshire Hathaway. Buffett showed their performance numbers. Munger managed a fund prior to partnering with Buffett. He lost 30-31% per year in 2 consecutive years. Despite this, Munger was one of the best investors in the world.
Buffett and Munger have both said that their portfolios have gone down 40%, multiple times.
Try to imagine your portfolio going down 30% per year. After two years, your portfolio would be down 51%.
I always thought that Buffett’s secret to success is that he has a stomach of steel, in order to handle the rollercoaster rides. I was wrong. He doesn’t. The reason he and great investors like Charlie Munger can seem to stomach these rollercoaster rides is because they are not on the rollercoaster rides. This is because they do not subject their stomachs to stock price volatility. They subject their stomachs to the business metrics.
STARBUCKS and APPLE
Near the bottom of my article “TOP 4 REASONS TO INVEST IN STOCKS“, I gave the example of Starbucks, which shows that its profit line was relatively stable, while its stock price dropped approximately 70-80%. Unlike Starbucks, Apple’s profits in 2007-2009 never dropped. It was a stable and grew every quarter in those years, whereas Apple’s stock dropped 50%.
Buffett subjects his stomach to the stable profit line. Others subject their stomachs to the stock price drop. They get nauseous, want to vomit, get angry and sell.
Because stock prices are so volatile, this is what causes people to lose money. When the stock goes down, most people think it will be permanent, so they sell. Sometimes, it takes 1-3 years for stocks to recover. It took 12 months for Apple’s stock to recover from the 2009 drop. For most people, this feels permanent. If you cannot handle these kinds of drops, do not invest in stocks. You will lose your money.
Stock market never goes in a straight line forever. Recessions and bear markets will always come. Stocks can and will likely go down 40-50% again in the future. If you cannot handle this, you will lose money.
I bought a stock that went down 95-97% and it took 2.5 years to recover to my breakeven point. Try to imagine doing that. If you cannot handle it, you will lose money.
In addition to Apple, another good example is Netflix. In 1995, I gave a presentation about how the internet is going to disrupt many industries. I told the audience that eventually people will be able to read the news in Los Angeles before Californians wake up. Essentially, print newspapers will be disrupted by the internet. I told the audience that Blockbuster will go bankrupt because people will eventually rent or buy movies over the internet, instead of renting VHS cassettes, VCDs or DVDs. We had distributed feedback forms to the audience. After the audience left, we read the feedback. One woman wrote: “I work for Blockbuster. You said that Blockbuster is going to go bankrupt. What should I do?”
In 1995, I essentially predicted Netflix. This is at a time when most people accessed the internet by using a land phone to call an ISP and then putting the handset onto a modem. The maximum speed was 48.8Kb/s.
But I wasn’t an investor at the time and I didn’t learn how to invest through stocks until 2008. I was a techie until 2008. Hence, I missed out on one of the biggest stock runs in history. Since going public in May 2002, Netflix stock has gone up approximately 260X, which is 26,000%, which means that if you invested $10,000 in 2002, you would have $2.6 million today. However, during that time, you would have been on a hair-raising rollercoaster ride, if you focused on the stock price instead of the business metrics. In 2011, the stock dropped approximately 81%. But if you knew with confidence that movie rentals were going to go onto the internet, you would not have been freaked out by the stock volatility.
In addition to Netflix, another good example of stock price versus business metrics is Roku. Roku’s rollercoaster would make Disney World envious. In 6 months in 2018, it went up 152%. Then in less than 3 months, it dropped 64%. See chart below. I bought it when it dropped to ~$44. I recommended this stock to a friend near this time. Then it dropped 38% to ~$27. For most people who get this kind of recommendation, they would never have bought it and never looked at it again. I bought more at ~$30.
Then it rose 430% from ~$27 to ~$170 on 2019-09-06. Then it dropped 41% in 3 weeks to $100.
If you cannot handle this kind of volatility, you will lose money. You will become nauseous and stressed out. You will also spend a lot of time staring at the screen to keep an eye on the stock price every day.
However, you will be able to handle this if you focused on Roku’s business metrics instead. If you followed Roku’s revenue and subjected your stomach to this, you would have slept well. Below is Roku’s revenue chart, showing quarterly results from March 2017 until June 2019.
It is almost a straight line. Not once did the revenue increase or decrease as much as the stock price. Unfortunately, few investors know what the revenue is doing or how much it is, but most know what the stock price is doing. Few understand Roku’s business and industry, which is far more important than stock price volatility.
If you buy stocks, you must think like a business owner, not a stock investor. You must realize that you are buying a business, not a stock. If you think like a stock investor or stock trader, you will lose money or not make that much. In order to be a business owner and feel confident about your business, you must understand the business and industry that the company is in. This is why Buffett never invests in businesses that he does not understand. This is also why Buffett has said repeatedly that he does not care if the stock market is closed for 10 years.