Individual Stock Investing

Investing in individual stocks has been a relatively declining allocation in most self-directed investor portfolios. The shift from active investing to passive index investing has primarily come at the expense of active mutual funds, but it has also replaced individual stock investing. Many investors who would have researched and invested in individual stocks are now simply picking low cost index products.

Individual stock investing can be a very broad style with a broad definition. In this post we will target long-term stock investors, not traders or investors who are effectively mimicking an index product. Investing in an index-cloning method with individual stocks seems quite pointless. Major stock ETFs are charging just 0.05% per year in management fees. Index cloning may seem appealing as you have direct ownership of shares, but this style of investing has a very low potential of excess returns.

The goal of individual stock investing should be to hold corporations that are durable and have a record of long-term growth in earnings and value. This takes work, but can result in a very low maintenance portfolio that is highly tax efficient.

Individual stock investing can easily be implemented in just about any kind of account: RRSPs, TFSAs, and non-registered investment accounts to name of few of the most popular. All you need is an online brokerage account and some money to get started.

As with any investment strategy, it is important to take a long-term view and always be mindful of your current exposure to various forms of risk. Market conditions can change very rapidly and catch people off guard. Understand what is driving your portfolio returns—both positive or negative.

What is Individual Stock Investing Exactly?

Investing in individual stocks is the classic form of investing. Instead of looking at the broad market, news, economic conditions, and other noise, you behave like an actual owner of a company. Your ownership stake may be small relative to the overall size of the company, but that doesn't matter to you and your view of investing. You simply buy shares directly in a company that fits your view of a well-run business that should be profitable for decades to come.

With individual stock investing you have a massive range of companies to choose from. The Canadian market has 3,500+ individual stocks listed. (More than half of those are tiny stocks on the TSX Venture Exchange.) You are not restricted to the local exchange; U.S. exchanges have another 5,000+ stocks listed. There are also more than 6,000 companies listed on the major European exchanges.

As an individual stock investor, you analyze the companies you invest in as if you were the actual owner of the company. This mindset is arguably very different from the perspective of many index investors and is certainly different from most traders.

All investing and trading requires great discipline, but perhaps this is most true in stock investing for the long-term. To be successful, you cannot worry too much about the price the market assigns to a company. Certainly in an optimistic market the price for certain companies may far exceed their true value, but there are also opportunities to buy good companies at a price where the value proposition is very good (aside from them being great companies).

Thinking like a business owner is difficult when you see the price move up and down daily, but it is not impossible when you apply a simple local analogy. For example, if you own a small business that manufactures a complex widget from steel, you would not care about what the market values your company shares at from day to day. Instead, you would focus on operating your company: being profitable, growing your business in a responsible way, holding enough cash to get you through the slow times, the current price of your inputs (steel, machinery, and labour), the demand for your widgets, your inventory levels, ensuring you are not overly indebted, and so on.

As an individual stock investor you have to think the same way. The main difference being that you have no real control over the operations of the company. Instead, your most important metric may be assessing the management. You are entrusting them to do what you would do if you owned the business.

For this reason, as an individual stock investor you must invest as if you were an absentee owner of a business. You use the tools provided by the company and regulators to ensure you are investing in a good company. You analyze company reports and make sure the company management stays true to the behaviour you would expect of your chosen manager for your business.

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The Benefits of Individual Stock Investing

There are many benefits to investing directly in individual stocks. You can be selective about the companies that you choose to invest in and hold for the long-term. In a market environment where many things are grossly over-financialized this can be a huge element of safety. You can easily avoid the companies in the market that are the most irresponsible in their operations and financial management.

There can also be an element of safety when investing in single companies by focusing on alternative metrics from the stock price. Instead of focusing on the share price, you might focus on the book value of the company shares, the company operating cash flows, net income, or some other measurement that is more meaningful to a business owner.

There are enormous tax benefits for investing long-term in good individual companies in a non-registered investment account. As an individual stock investor you are buying every company with an intention to hold that company forever. After all, you are a business owner. You would never buy a small business in your local area with the intention of waiting for someone to assign a much higher value to it sometime in the near future upon which you would sell. It would typically take a lot of analysis and sleepless nights before you would sell something that you put so much work into.

This means you are unlikely to realize capital gains on a regular basis. If you do realize capital gains on one of your companies, it is more likely to be for tax benefits, such as capital gains harvesting, than for a simple trading decision.

If you must sell a position, possibly because something has changed in the management or business that is material and contradicts your investment philosophy, you may actually be booking a capital loss instead of a capital gain. You can use this capital loss to offset future capital gains, or simply to roll a portion of a current position to increase the cost basis of your shares (capital gains harvesting).

You can also control the dividend yield of your investments. While the dividends should be a distant secondary consideration in selecting a company to purchase, controlling your dividend yield when investing in a non-registered account is a great tax advantage. If you are a high income individual, you can tilt your stock selection towards companies that pay a lower dividend yield—particularly if they are foreign companies. On the flip side, a low income individual may choose moderate to higher dividend paying companies as their tax burden would be much lower on these dividend payments.

Foreign investments held within your RRSP can be completely exempt from withholding taxes, depending on the country where the corporation is listed and headquartered and the tax treaty Canada has with that country. This could save you 15% to 30% on each dividend payment. The United States and United Kingdom are two countries that you might consider investing in with your RRSP to tax advantage of these tax rules.

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Avoiding "Closet" Index Investing

When you are investing in individual stocks, there is a danger that you may actually be "closet" index investing. Or cloning the behaviour of an index intentionally or unintentionally. There is nothing wrong with this per se, but it does beg the question why you are picking individual stocks in the first place. After all, you can purchase the main benchmark index funds for a cost of 0.05% to 0.10% per year. For management fees this low, if you want to invest in individual stocks you should be different.

There can be comfort in "closet" indexing. We know from a large number of studies that it is quite difficult for the average stock investor to beat the comparable benchmark index. This could include the S&P/TSX Composite Index for Canadian stocks or the S&P 500 Index for U.S. stocks.

But difficult does not mean impossible. Many patient self-directed investors beat the index decade after decade through extreme discipline and careful company selection. You should only invest in individual stocks if you have these qualities.

To avoid becoming a "closet" index investor—effectively tracking the benchmark but putting a whole lot of unnecessary work into their investment process—you need to own businesses in a way that is unique from the index.

Aside from choosing stocks from some different industries, you should shun the common convention that states more diversification is better. If you own more than 20 stocks in your portfolio, you are much more likely to be a "closet" indexer. This is particularly true if you invest in large-cap stocks.

Only choose stocks where you would happily invest your entire portfolio in that one business. In other words, you believe in the company management and business so much that you would buy the entire company if you could and own that company forever as an absentee owner.

A very good individual stock investor may hold fewer than 10 stocks in their portfolio because they truly trust the companies they invest in.

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How to Choose Companies for Your Portfolio

The most difficult part of discretionary investing in individual stocks is choosing which companies to allocate your capital to. There is no easy answer to this question. However, a few hints can help point you in the right direction.

Companies that have a record of increasing free cash flows each year can be great long-term investments. These companies are likely to have pricing power and a steady path of continuing growth. Cash flows can often tell you a lot more about a company than the income statement. Income statements are subject to accounting tricks as this document determines taxes owing. In contrast the cash generated by a company's operations is a true marker of profitability and the use of that cash through investment or paying down debt can tell you about the management's priorities.

Companies that have a growing book value per share can also be great long-term investments. Book value can represent the the value of assets the company holds. However, it may be even more important to examine the liabilities and share count. Many companies that expand aggressively by purchasing other companies will have a pattern of growing debt and/or growing share count that dilutes the true assets held by individual share holders.

Look for companies that are conservatively financed. This means they have a low amount of debt relative to their operational cash flows and their assets. Conservatively financed companies are far more likely to survive industry downturns. Even more importantly, these companies are unlikely to go bankrupt. These are companies managed for long-term survival.

Screen companies for good management. This can be difficult to quantify; however, there are often clues that can be found in company reports. Executive compensation is an important starting point. Companies where executives receive high pay packages loaded with stock options are more likely to make poor long-term management decisions. Find companies with a stable management team; high management turnover is indicative of management problems. Finally, look for companies where the management owns a decent portion of the outstanding shares. This will align their interests with yours as both of you are shareholders. Some of the most well-run companies are those where a large portion of the shares are held by one or several families.

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Allocating to Individual Stocks

Allocating your money to a portfolio of individual stocks is an exercise in caution. You should view every company you invest in as if you would purchase the entire company as an absentee owner; nevertheless, you should still hold more than one company in your portfolio. After all, you are an absentee owner with no control over the company's operations.

The goal should be a sustainable portfolio where you hold a handful of excellent businesses for the long-term. You will know these businesses well and you can recognize opportunities to buy more shares of these companies.

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How Much Capital to Invest in Each Company

To stay safe and promote moderate diversification across a handful of good companies, you should try keep your exposure to any one company at less than 20% of your portfolio. This simple rule will force you to hold at least five companies to be fully invested.

You should also invest a minimum of 5% of your portfolio in a single company. First, if you hold positions smaller than 5% of your portfolio, that company will have no real impact on your portfolio. Second, this simple rule will ensure you hold no more than 20 companies in your portfolio when you are fully invested. Small positions may be indicative of your hesitation in the company as an investment. You should be confident in every company you invest in.

Following these guides, you should allocate between 5% and 20% of your total portfolio capital towards each company you hold in your portfolio. This is a solid allocation where the company will have a meaningful impact on your portfolio while still promoting some diversification across a few companies in different industries.

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The Importance of Cash

Cash is an important and often overlooked part of every stock investing portfolio. Too many stock investors hold nearly no cash at all, arguing that cash carries an opportunity cost that reduces your long-term returns.

I take a different position on this (and so do most of the world's best stock investors). It is important to understand that higher stock allocations have a declining benefit to your portfolio. The difference in long-term performance between a portfolio that holds 80% stocks compared to on that holds 100% stocks is minimal at best. Being fully invested in stocks all the time means you will lose out on some of the best buying opportunities.

From time to time one or more of the businesses you have in your portfolio will go on sale. It could be part of a slowdown in the company's industry, it could be a general stock market or economic downturn. The reasons don't really matter as much as your continued confidence in the underlying business of that company. Well run companies will survive these downturns because they are conservatively financed; many take advantage of the opportunity to consolidate holdings and possibly purchase a competitor or a supply chain partner for a very attractive valuation.

A reasonable cash balance allows you to take advantage of these opportunities as an owner of a collection of businesses. When the market prices one of your businesses at a discount valuation, you can buy more shares and increase your participation in that business.

I believe a cash balance between 10% and 20% of your portfolio is a reasonable number to target. A good strategy is to begin with a 10% allocation to cash. Then sit back and let the dividends from your holdings and new account contributions slowly increase your cash balance over time. If you see a good opportunity to add to one of your companies, deploy some cash towards buying more shares. Alternatively, if another excellent company comes on your radar at a good valuation, you can deploy your cash to purchase a stake in that company.

Very rarely you may be in a market environment where several of the businesses you own are on sale. The 2008-2010 period is an excellent recent example. Many great companies had their share prices pummeled by investors. Business owners could pick up shares for as little as five times the recent averaged free cash flow. That equates to a 20% cash yield on your investment. These are opportune times to deplete your cash holdings down to nearly zero.

Make sure your cash balance is invested to try keep pace with inflation. Short-term government bonds can be a good, highly liquid place to keep your cash balance as you wait for good buying opportunities.

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Preventing Catastrophic Losses

Preventing catastrophic losses is a critical component of good portfolio management. By catastrophic losses I mean permanent impairments of capital that can have devastating repercussions on your overall wealth.

The goal of any portfolio should be to preserve and grow the purchasing power of the portfolio over time. Notice this is very different than targeting a return of XX% per year, having no drawdowns over XX%, and other metrics than many use in the financial world. Drawdowns and risk metrics are important for technical trading, but you cannot transfer this to investing in good companies as a business owner.

The first line of defense in avoiding catastrophic losses in an individual stock portfolio is to only invest in good companies that are conservatively financed, are well run by management, and show growing cash flows over time. Steady, sure, but boring growth is much better than exotic, high speed, debt fueled growth. Good companies don't go bankrupt and they don't lose massive amounts of money in the pursuit of growth. Avoiding companies that have the potential of going bankrupt is a huge advantage to avoiding catastrophic losses.

As an absentee business owner, you must also monitor your collection of businesses. This doesn't have to be an in-depth analysis of your company and news related to your company or its industry on a daily basis. Take just one hour each month to read any press releases from your company, read the quarterly or annual reports, read the earnings call transcripts, and so on. All you need to do is make sure your company and its management have not morphed into a company you would never invest in. High management turnover, sudden changes in executive compensation, hostile corporate takeovers, and changes in the balance sheet may require further examination.

Moderate diversification is another layer of protection. By holding 5 to 10 businesses in your portfolio from several different industries, you are shielding yourself from the possibility of long-term damage to your portfolio's cash flows.

If one of your company's has a significant change in their risk profile and it no longer fits your criteria for good investment, it is very important to sell that position regardless of the current stock price or analyst outlook for the company. Aside from purchasing at reasonable valuations, the stock price shouldn't drive your buying decisions or selling decisions. Focus on the operations and management.

It is also important that you are highly disciplined in your portfolio management. You cannot sell companies in your portfolio simply because the share price has dropped or the economy is in a recession. These should be buying opportunities! Many well-intentioned stock investors buy companies when share prices are going up and feel they will hold their positions through anything, only to sell in pessimistic periods like 2008-2010 at devastating losses, permanently impairing their capital.

A stock portfolio of a few good companies is likely to experience declines comparable to or higher than the overall stock index. This is because diversification and the cap-weighted system protects the index. As a business owner you must have the confidence to ignore the share price declines, or add to your positions when the market is clearly mispricing your business.

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