Patrick O’Shaughnessy is a portfolio manager at O’Shaughnessy Asset Management, where he manages money for both institutions and individuals. He is the son of James O’Shaughnessy, author of What Works on Wall Street, a book I intend to review in the future. Patrick is a Chartered Financial Analyst and well respected within the investment community.
The book talks about the ‘millennial edge’ – that is, the time in the future that Millennials have to grow their wealth before retirement. The younger Millennials are, the more risk they can take on as they have that time to recover losses. A millennial’s portfolio will typically look different to a pensioner’s portfolio, which may consist of income stocks rather than growth stocks. The Millennials came of age in the worst economic environment since the Great Depression, and they’re still skeptical of the stock market given the crashes and bailouts of the 2008 Financial Crisis. They also won’t be able to take advantage of pensions and social security like the baby boomers have – aging populations mean that the demographic pyramid is top heavy and unable to be fully supported by the younger generations.
The second chapter deals with paying oneself. After bills and living expenses, most Millennials do not put any money away to save for their future, which is harming their future selves. By investing early and efficiently, one can set their own future up very nicely. Millennials have grown up in age of information where it is freely available and they should take advantage of this.
Patrick lists three key investing principles: 1) Go global (which I do not entirely agree with although I see the reasoning of diversity – a solid global fund paid into every month is not a bad thing), 2) be different, and 3) getting out of one’s own way. This last one uses the example of running away from danger as human trait that serves us well, but selling out completely in a market crash is not the way to go. We are biologically programmed to fail as investors, and so by conquering our emotions, making automatic payments, we can focus ourselves on the long term.
Rules for Milliennials
Rule #1 for the Millennial Money strategy is to buy companies that return cash to shareholders and/or pay down debt from positive cash flows.
Some CEOs are empire builders, and they spend on property, buildings, and equipment to expand at an unsustainable rate. Growth is quick, but the market has historically tended to overprice these stocks as empire builders have performed terrible relative to the market.
Reckless acquiring is another way for companies to spend capital and grow. Acquisitions can and do make sense, for example a formidable competitor or a technology that would produce synergy within the business, but it’s important to see if a company is overpaying for the acquisition. This shows up on the balance sheet as ‘goodwill’, and is not a tangible asset. Buy and build is a great strategy if done by prudent management, but incessant acquisitions for the sake of acquiring is rarely a good strategy.
The next group of companies to be wary of are cash fiends. Is the company raising cash from creditors or diluting existing shareholders? Equity raises are a necessary evil in growth companies, but historically the vast majority of all companies listed on the AIM market have destroyed shareholder value.
The best type of company to own in the Millennial Money strategy is the companies that are shareholder stewards. These companies are either paying down debt or giving cash back to shareholders in the form of dividends or buying back shares. Companies that reward shareholders have historically performed better in the stock market.
Rule #2 for the Millennial Money strategy is to buy companies that earn high returns on their investments
Investors buy a stock because they want a return on their investment – the higher the better. Therefore, we should want our companies that we own to make the highest possible returns on their investments too. We can calculate this by using a measurement called “return on invested capital”, and this is done by taking the earnings and dividing it by the total amount invested.
Rule #3 for the Millennial Money strategy is to insist on strong cash flows: real earnings, and not manipulated earnings
Investors of all levels pay too much attention to bottom-line earnings; they should instead be focusing on real cash flows (free cash flow). There are many tricks to manipulate earnings, but cash never lies. As Alfred Rappaport says, “cash is a fact, profit is an opinion”. In most instances, it’s the managements opinion! They are the ones who have discretion to delay projects into the next quarter, or as we saw in Tesco’s case, aggressively recognise recognition that was sometimes never even earned. The best businesses are the ones that generate lots of positive free cash flow through their operations.
@PhilJOakley has done some excellent articles on how to look and find out if companies are converting their profits to cash. The worst companies are those that create their earnings to satisfy short term City expectations at the expense of the long term health of the company. The book cites a study where 78% of management admitted they would be willing to sacrifice shareholder value to smooth earnings reports, and 55% even said they would avoid projects that would cause them to miss short term earnings expectations, even if those same projects would create larger positive value for shareholders in the future! 77% of financial executives admitted that this helps them feel safer about their jobs.
There is a simple way to screen for real cash flow: take reported earnings, subtract operating cash flows, and divide this result by the market cap. This is a measure of the company’s earning quality. The Millennial Money Strategy wants companies with outstanding earnings quality because these are the companies that have historically led to quality returns.
Rule #4 for the Millennial Money strategy is to never pay too much for any stock, no matter how fantastic the company. In the stock market, the less you pay, the more you will earn.
I personally disagree with this, because value has consistently underperformed momentum investing strategies, and you’ll never own any of the stock market monsters by buying value. Companies like Fevertree, Boohoo, Asos, have all traded on high PE multiples which some would call expensive. However, so far Fevertree has consistently beaten expectations and grown hugely, so was it ever really expensive, or justified? That said, when a high PE stock gets it wrong, the fall can be huge. Buying value will avoid overpaying, and so limit the downside. For long term investors looking to compound their capital this is definitely something to consider.
The book argues that by buying companies that have an attractive valuation and generate positive free cash flow, the strategy will continue to work in all market conditions because there will always be stocks that are underpriced and underappreciated, and there will always be stocks that are trading far too high for their growth.
Rule #5 is to find stocks that the market is just starting to notice
My earlier criticism has been acknowledged with this rule, as it’s common knowledge Millennials don’t like to wait too long for anything. Focusing on value can find great opportunities, but many stocks are cheap for a reason, and sometimes the market will take its time to re-rate them. Momentum avoids this because as Willie Nelson said, “the early bird gets the worm, but the second mouse gets the cheese”. The key to this is to buy the stocks that are the cheapest, but of those cheapest stocks then look at the 20% of those stocks that are growing the fastest.
The Millennial Money checklist
- Stakeholder yield is greater than 5 percent
- Return on invested capital is greater than 30 percent
- Operating cash flow is greater than reported profits (earnings quality)
- Enterprise-value-to-free-cash-flow is less than 10 times
- Six-month momentum in the top three-quarters of the market