Look man, I’m not saying we should burn down the colleges…
But get a load of this…
There is a small academic movement happening today that argues “2 + 2” doesn’t always equal “4”
Have you heard about this?
Now, before you delete this email and run off to the liquor cabinet, let’s at least hear them out.
After all, given the way that stocks continue to rip to new highs with no economic numbers to support them, maybe these people are onto something…
Now, just take a minute here to wrap your mind around this one.
A PhD student at Harvard University in biostatistics has said on Twitter that scientists should seek to serve society instead of seeking the truth.
It appears that the crosshairs are now on the “scientific method.”
The student recently Tweeted that “Statements like ‘2 + 2 = 4’ are abstractions.”
The author went on to say that if someone “put a rooster and hen together and I came back a year later and there were three of them (1+1=3) or they might say I left a fox and a hen together and later I came back and there was only one (1+1=1).”
I suppose with the right type of scotch, you can make any math work.
But there are reasons why one should be concerned about this commitment to reducing the importance of “truth.”.
First, it was a central phrase used in George Orwell’s 1984. It was a dogmatic statement, no matter how insane, like “War is Peace” that party members were expected to believe despite what logic is telling them.
The second is just the lengths that people will go to try to make a point for reasons that are only known to them. Take one of the people defending the PhD student who said that 2+2 can equal 5.
One wrote: “There are two factories. Each factory has two fully operable machines, as well as half the parts to build another one. If the two factories were joined into one, and the two halves of parts were built together, it would be five total machines. A case of 2 + 2 = 5.”
You don’t need any scotch or Allen wrenches to know that this is actually a case of 2.5+2.5 = 5. That’s basic math. There’s nothing controversial about it.
Yet, here we are on a Saturday, having THIS conversation.
There Have to Be Rules
I think that “2 + 2 = 4” is the most basic rule of mathematics.
But this absurd debate got me thinking:
What are my most basic rules of investing for the long term?
What is tried and true, and no foolish descent into obscurity can undermine how I define a “sound investment?”
When I buy stocks for my Family portfolio, I plan to leave them there for a long time. So, to better measure the best stocks to own, I build my strategy around five rules.
Every stock should pass all five tests (unless there is a compelling high-growth reason that grabs my attention and makes me HAVE to own it). Let’s break them down.
- I Like When Management Has Skin in the Game
If you’ve read my work, you know I want executives and directors to own the stock. They don’t have to put their life savings into the company. But I want them to have enough money in the stock that if they screw up, they’re going to have to sell their vacation homes to make up the difference. Incentives matter. And a bureaucratic management team is a death sentence for growth prospects. Salary collectors are not going to make me rich(er).
- I Want a Company with a Strengthening Balance Sheet
Too much debt will kill even a great company. I don’t need firms to be debt free. I just want to know that they can generate more cash flow than they owe in interest payments. Otherwise, they’re dabbling in Ponzi finance.
The easiest way to measure the financial health of non-financial firms is to use the Altman Z score. This is a ratio that was developed 50 years ago to measure credit risk. I want that number to be 2 or higher. If it’s a bank, I’m looking for the highest equity to asset ratio possible.
- I Like Companies with Strong Fundamentals
We want improvement in the underlying business. Again, it all comes down to one number. Professor Joseph Piotroski of Stanford created the tool we need. His nine-point F-score model measures a company’s current fundamental condition. It also tells us if conditions are improving. You want a minimum score of 6, and the higher, the better. A company with a high score has high returns on equity and assets. They are not issuing a lot of stock. They are profitable. They are reducing debt levels. Their margins are improving.
- I Want to Know What they Do and Why They Do It
You ask this question to avoid the next Enron. Too many people never ask this question. Failure to do so is why you see some people crying into their trading statements after they learn about “accounting oversights.” I don’t need to be an engineer to know what a computer chip is. I don’t need a chemist to know that a new drug makes people healthier. I want a simple mission, vision, and action statement on what the firm can do and why it does it.
To quote Lewis Black, “If you own a company and it can’t explain in one sentence what it does, it should be illegal.”
- I Want Companies that Stand the Test of Time
Finally, I ask if I think this company will remain dominant in 20 years. Will there still be demand for their products when I hand over this portfolio to my children?
I know Amazon (AMZN) will be selling consumer products and web services in 20 years. I know that AT&T (which is an early pick in my Family Portfolio) is going to dominate telecom and pay strong dividends for years to come. I know that the food tech company that is already up 70% since I bought it is going to be innovating in a world of increased food demand.
But if I cannot get a clear picture of what a company will look like, it may not have the staying power to make me rich(er).
Breaking It All Down
If I can find a stock with the first three characteristics, I am interested.
If I like my answers to the final two questions, the stock is a serious candidate. Now, as I said, I will conduct qualitative analysis and determine if this is the right stock for me.
But for now – keep in mind that just 4% of companies delivered all of the gains in the U.S. stock market between 1926 and 2015.
Companies that can pass all five factors of my checklist are more likely to be in the 4% over the next few decades.
We’ll be revisiting real estate next week. There is a lot of money sloshing around between the cities and the rural stretches of the country, and I don’t want to miss out.