Why Business Focused Investing Is The Best Strategy

The wide array of stock market investing strategies available to retail investors is staggering.

There are libraries full of books written about technical investing, which relies on making short-term trades focused on chart metrics such as moving averages, volume, and price movement patterns ("head and shoulders", "double top", etc.).

There are the Benjamin Graham, deep value, "cigar butt" style investors, who stare closely at earnings and cash flow ratios, trying to catch an oversold situation that will generate a relatively short-term gain.

There are the momentum investors that follow the trend, trying to hop on the "rocket ship" stocks and ride them all the way to the top - jumping off, of course, before the inevitable return back to Earth.

But one kind of investing that we don't see talked about much is actually the most effective.

If you examine super-investor Warren Buffett's annual shareholder letters and statements, you'll see that he follows this strategy. If you look at the Forbes billionaire list, this investing strategy is really at the core of their wealth.

It is the single most effective and low-maintenance investing strategy there is - if you are willing to stick with it.

What is it?

OWN great companies for the LONG-TERM, and let your wealth compound with theirs.

We call this: Business Focused Investing.

In this article, we'll lay out the business focused investing philosophy and why it is the BEST strategy for individual investors to build long-term wealth.

How Stocks Are Chosen For Business Focused Investing

In technical investing, stocks to buy are chosen based on chart indicators, which also informs when to sell.

In value investing, stocks that trade far below a calculation of their worth based on their earnings or cash flows are chosen. You sell when the stock price exceeds that fair value calculation.

In momentum investing, which is really a branch of technical investing, stocks are chosen by their trend, often using moving averages. Stocks trading above moving averages are "momentum" stocks and can be bought, and stocks trading below moving averages are often sold or avoided.

So, how are stocks chosen using the business focused approach?

Instead of looking at stock characteristics, like price trends or valuation, we focus on characteristics of the underlying business. Specifically, we need to look for characteristics that have been shown, time-and-again, to separate sustainably great businesses from mediocre or poor ones. After years of research into what those are, we've boiled it down to 3 simple, easy-to-understand questions:

1. Does the company have rising revenues?
2. Does the company's customers pay it on a regularly and reliably recurring basis?
3. Does the company have one or more of the recognized economic moat protections that guard against competition?

We will go into more detail on each of these in future articles. But, if the answer is "YES" to all 3 of these questions, we probably have a great business to consider investment in.

What about when to sell? That's simple as well. We keep asking the same questions. Over time, companies and industries evolve. Management mis-steps, technological innovations, or shifts in customer desires can change the outlook. If we still get a "YES" for all 3 questions, we shouldn't sell. If we start getting "no" or "unsure" answers, then we start considering a sale.

The great thing is that the answers to these questions usually change slowly and gradually. Unlike technical or momentum investing, we don't have to review everything daily. A couple times a year usually suffices. That's far easier!

How Long Is The Holding Period For Business Focused Investing?

Most stock strategies have pretty short holding periods. Technical and momentum investing often involve holding periods of just a few weeks. Even pure value investing has been shown to work best over periods of just 6-12 months.

With business focused investing, the target holding period, as Warren Buffett likes to say, is forever.

Now, clearly, that's not always going to be the case. As stated in the previous section, it is always important to review holdings at least a few times a year, asking the key questions. There ARE going to be times where our initial assessment of the 3 questions proved inaccurate, or when market conditions forced a change to the answers.

In these cases, it might be time to sell.

But in the vast majority of business focused investments, we expect to hold a MINIMUM of 3 years, and hopefully far longer. Again, back to Buffett and one of his more famous quotes:

Time is the friend of the wonderful company, the enemy of the mediocre.

Business focused investments are meant to outperform the market by wide margins over time. They may or may not outperform it in a week, a month, 6 months, or even a year. But over a 3 year period, we expect to beat the market, and by a good margin.

How Many Stocks Should I Own In A Business Focused Approach?

One of Wall Street's axioms is: "diversification is the only free lunch" (actually coined by Nobel laureate Harry Markowitz in the 1950's).

What does this mean?

It means simply that diversifying your investments is a very simple protection against unforeseen mishaps. It protects you against inevitable bad decisions. Even the best investors miss on 40% or more of their stock picks.

Business focused investing does not really veer far off of the conventional wisdom on this. Numerous studies have shown that owning 20-30 stocks is an ideal balance of risk management and ease of maintenance. We agree on this one.

The reason business focused investing beats the market is not based on the number of stocks you own. It is based on the average QUALITY of each of those stocks being better than the average quality of each stock in the S&P 500.

To sum it up, we think an absolute minimum should be 10 stocks. A "sweet spot" is 20-30. If you are an enthusiastic investor who doesn't mind dedicating more time to your portfolio, even 50 stocks is great. Beyond that it gets difficult to manage, and you end up adding stocks that perhaps are not of as high a quality. This will bring down overall portfolio returns.

Why Should I Use Business Focused Investing?

Now we get down to the key question: why choose a business focused investing strategy, instead of the others?

Here are the reasons:

• It is used by the world's greatest investor. Of course, we are talking about Warren Buffett, widely considered the world's greatest investor. He is in the top 10 richest people in the world, wealth he created by long-term ownership of Berkshire Hathaway. In turn, Berkshire was built on partial or full long-term ownership of many different great companies, including American Express (AXP) (60+ years), Coca-Cola (KO) (30+ years), GEICO (40+ years), See's Candies (almost 50 years), and many others. Buffett is certainly not a technical trader or momentum investor. Although many have labeled him as a "value investor", in truth he isn't that either. He stated many times that he would rather buy a GREAT business at a FAIR price, then a fair business at a great price. Buffett is undenaibly business-focused.
• It is the underpinnings of the world's greatest wealth. Look at the top 10 in the Forbes billionaire list. Do you see momentum investors, or traders, or even "cigar butt" value investors in there? No. You see folks who own large percentages of the world's greatest businesses - and have for decades. The fact that, in many cases, they created those companies is incidental - any investor could have ridden those stocks to ridiculous compound gains as well. This has been true throughout industrialized history, all the way back to Vanderbilt, Rockefeller, Carnegie, and Ford.
• It is simple relative to the other strategies. Let me ask you this: can you describe to me what MACD is? How about Bollinger Bands? Can you do a discounted free cash flow calculation, using a weighted average cost of capital estimation? Probably not, right? But can you tell me if customers pay Netflix (NFLX) on a regularly recurring basis? Can you tell me if you buy Coke or Pepsi out of habit, without even thinking about it? Can you take 2 seconds to look at a single line of revenue numbers and tell me if they are growing at a good rate? I bet you can.
• It requires less time than other strategies. We've touched on this a bit. Technical/momentum strategies require you to keep track of your stocks almost daily (at least weekly). Value strategies need to be reviewed frequently as well, as financial numbers change quarterly. Business focused investing, on the other hand, only requires an occasional review of the business characteristics - maybe once a quarter, or a few times a year. You don't have to spend time staring at your portfolio on a daily basis to win here. In fact, you really shouldn't.