Mark Lamonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs. 

Shani Jayamanne: So, Mark, you wrote an article last week and said that you're getting close to putting some of your cash into the market. So, I thought it would be a good topic for us to explore today. So, for years you've been really negative on the market and earlier in the year when we had falls, you warned to people against buying the dip. So, what's changed?

Lamonica: Well, I think a good place to start before we get into my thinking is what is happening with markets. So, the optimism that investors had that central banks would engineer some sort of soft landing where inflation was brought under control and the economic hit was minor, has pretty much evaporated.

Jayamanne: And a lot of that had to do with the Chairman of the Federal Reserve coming out in August and reiterating commitment to fight inflation and inflict economic pain to do it. And with that speech, the markets started to go into freefall again.

Lamonica: Yeah. So, that's right, Shani. So, in the U.S., the S&P 500 broke through the low that it hit in July, and there has been a bounce in the last couple of days. So, we are recording this on the 6th of October, so on Thursday, there has been a little bit of a bounce. But still, breaking through that low wasn't great. And then, locally, the ASX has bounced a little bit too but was hovering right above that low reached in July. And then, of course, Shani, there is the U.K. and Europe.

Jayamanne: Yeah, markets didn't respond well to the new U.K. Prime Minister's plan to turn the economy around with bond yields skyrocketing and the pound plummeting. And then, we have Europe, which is reeling with 10% inflation and an economy that's feeling the impact of Russia cutting off natural gas supplies.

Lamonica: Yeah. So, there's a lot going on, Shani.

Jayamanne: There is a lot going on. And investing is about optimism about the future, and right now, there's not a lot of optimism out there.

Lamonica: Yeah, that is definitely true. So, it's just such a different feeling than earlier in the year where there was so much faith that things would bounce back. So, so much faith that this was just a brief dip, and the shares were on sale. It just feels different and feels like people are resigned to the fact that this will be a prolonged battle against inflation and that the victim is likely to be the economy.

Jayamanne: And as pessimism increases, it is potentially signaling that there is an opportunity out there and that seems to be what you're seeing. So, you've been quite vocal over the last couple of years about building up cash. And in our last portfolio review, you mentioned that you were close to 25% cash in your investment accounts. So, are you ready to start putting that to work?

Lamonica: Yeah. No, I mean, I'm starting to see opportunities and things are getting close to where I'm thinking about investing some of that cash that I built up. But I want to start with a very important caveat, and I'm going to talk about today – in this episode, I'm going to talk about the right situation for me. So, your situation is different, Shani, and everyone listening to this has a different situation. So, for everyone listening, your decision-making process should reflect that reality. And I do hope that expanding on my thinking provides a little bit of perspective.

Jayamanne: And I think going through your thinking will make another important point about investing and that's the importance of structure. This pessimism that we're seeing now and the optimism we saw around the buy the dip phase when the market drops started in January are, of course, emotional responses by investors, and emotions are always going to influence us as investors. But we need to strive to reduce their impact and our actions. And one way to do this is by putting structure around our thinking and decision-making.

Lamonica: And for listeners of this podcast, this should be a familiar theme. So, everything we constantly talk about is structure – so, defining your goals, calculating your required rate of return, and having an investment policy statement is all about structure, and that structure will guide your thinking and your actions at times like this, when things are stressful, and at times, like we saw last year, where speculative greed takes over.

Jayamanne: And structure comes in all sorts of ways. For instance, my plan is to keep investing no matter what. Given my age and timeline, I think the right move is just to keep putting money into the market. So, I obviously can't ignore what's going on given my job, but I can put structure around my investing so that it doesn't influence what I do. So, if the market is up or if the market is down, money automatically comes out of my paycheck and gets invested.

Lamonica: And structure starts with having a goal and knowing what you need to achieve. So, I need to earn a 6.9% return per year over the next 17 years to reach my goal, and my evaluation of any investment opportunities starts right there.

Jayamanne: All right. So, in your article, you wrote about a company that you're looking at and one you've mentioned before in this podcast and that American Tower. So, perhaps we can use that as an example for your thinking.

Lamonica: Yeah. And I've been looking at a couple of different things, but I did mention American Tower. But before getting into that process, I think it's important to talk about an underappreciated aspect of being a good investor and that is self-awareness.

Jayamanne: And self-awareness is important because we can design an investment approach around our inherent strengths and weaknesses as investors. And those strengths and weaknesses are mental – what are mental impediments that each of us have that can lead to poor investment decision-making.

Lamonica: That's right, Shani. I'm pretty good at keeping a long-term focus as we covered in our cash flow versus balance sheet episode, your favorite. And that's really because I don't care that much about how my net worth bounces around. So, that means in falling markets I'm really not too phase and I think it's unlikely I would ever panic sell.

Jayamanne: And you've mentioned the strengths you've had as an investor, the fact that you don't let the market swings influence your behavior.

Lamonica: Yeah. So, that's right. So, on the upside, that allowed me to take a step back and say things are getting pretty speculative, I'm just going to build up cash. And when the market falls significantly, I haven't really had that inclination to sell.

Jayamanne: All right. So, let's talk about your investing weaknesses because I know some of your other weaknesses.

Lamonica: Some of them should we have a whole episode where you just go through my weaknesses? They are pretty obvious, Shani. So, I think, everyone who knows me knows all of my weaknesses. But the issue I do have with investing is I seem to have this almost pathological need to get the best deal possible on anything I buy, and sort of this natural skepticism that I think serves me pretty well when things are going up, but from an investment perspective, it makes it harder for me to pull the trigger when I actually want to buy something. So, I just keep imagining that I'll be able to get in at a cheaper entry point.

Jayamanne: And we've talked about that before during the 2020 COVID-related market drop where you didn't invest as much as you would have liked.

Lamonica: Yeah, definitely. And that's why during this bear market trying to learn from my mistakes and as we said, put a little more structure around my decision-making.

Jayamanne: So, how do you think that your investing strengths and weaknesses play out as a competitive advantage when it comes to investing, because this is another important part of how self-awareness is critical in investing? Your competitive advantage as an investor is a key component of the investing approach you should take.

Lamonica: Yeah, that's exactly right, Shani. And we've talked about competitive advantages or sources of edge before. And in my case, I don't think I have an analytical edge or the ability to have a dramatically different insight about a company than other investors.

Jayamanne: And Analytical Edge is an interesting one because I think a lot of investors think that this is their source of advantage when in reality, they're just simply repeating conventional wisdom.

Lamonica: Yeah. And that's really that first order thinking we always talk about.

Jayamanne: Exactly. Like, there will always be more electric vehicles, so I'll buy a lithium miner because that is the material in batteries, and that's not actually an analysis.

Lamonica: No. Exactly. That first order thinking is basically the whole reason why we have thematic ETFs.

Jayamanne: Okay. So, if analytical advantage is not your competitive advantage or edge, then what is it?

Lamonica: So, I think it's a couple of things, but primarily, it is discipline around buy and sell decisions that I make, and that's behavioral edge. I think I'm able to eliminate a lot of the behavioral mistakes that investors make when they're driven by fear and greed. The other main competitive advantage that I believe I have and all individual investors can have is structural edge.

Jayamanne: The structural edge refers to the impediments that many professional investors have, which stem from the fact that they're investing other people's money, and they often have conflicting motivations associated with the fact that they're trying to keep their jobs and further their careers.

Lamonica: Exactly. And individual investors don't face those structural impediments when they're investing, which means nothing influences when you invest, and nothing influences how long you hold positions for.

Jayamanne: And having extremely long holding periods is an underappreciated advantage.

Lamonica: Yeah, and one that people just give up too easily and they just do that by trading too often.

Jayamanne: Exactly. Holding positions for the long term has the advantage of minimizing taxes and fees and letting compounding work fully to your advantage. Plus, study after study shows that when investors sell a position and buy a different one, the new position performs worse.

Lamonica: Yeah, because people are chasing returns, Shani.

Jayamanne: Exactly. Yeah. So, let's use an example to demonstrate how this all comes together. And we talked about the opportunity you had your eye on, Mark, which is American Tower.

Lamonica: Okay. Let's talk about American Tower. Now, we've mentioned it before on the podcast. And a quick summary. So, they lease mobile phone towers to mobile phone companies. And I won't go through all of those details, but I will say it's universally acknowledged that this is a pretty good business, and it happens to be just the type of company that I like investing in.

Jayamanne: And that's important because there are all sorts of approaches to investing that can be successful, but probably only one that works for each of us. So, what are you looking for in a company and why does American Tower fit the bill?

Lamonica: Well, I like boring companies.

Jayamanne: You like boring company? Is that why you hang out with me?

Lamonica: Companies. Companies, Shani. No, Shani is not boring despite her obsession with laksa, which you described – I actually listened to our old podcast. You said that's the first thing you think about every morning.

Jayamanne: Yeah, and the last thing when I go to sleep.

Lamonica: Even on a day when you've had it?

Jayamanne: Yes, especially on a day that I've had it.

Lamonica: Okay. Well – so, Will is going to Canberra in a couple of weeks. I don't know you actually cancelled your trip because of the weather. But yeah, people need to get out and try this laksa apparently. All right, so boring companies – companies, Shani, not boring company. So, to me, what that means is a company that does well in all market environments, and American Tower certainly falls into that category. So, people use data on their mobile phones in all different economic cycles. So, there is really no cyclicality there. And I deliberately avoid companies that are in new and emerging industries which are subjected to investor hype. And owning mobile phone towers is certainly not an emerging industry at this point.

Jayamanne: All right. So, why is that? Many investors are drawn to new and emerging industries that have the opportunity to change the world.

Lamonica: Yeah. And I understand that. Once again, this is the way I invest. It does not have to be the way everyone else invests. But those industries that seem really exciting and exciting to talk about, but there's a couple of downsides, and a couple of different things happen in these emerging industries. The first is that the competitive environment is often really volatile, meaning that there are lots of new entrants and because of the hype these are generally really well funded entrants. So, that creates lots of inefficiency and ineptitude, which is just papered over by access to lots of capital, and the competition that is inherent in all this jostling for market share just isn't great for investors.

Jayamanne: And it's often really hard to pick out the winners and losers in these industries. So, you might have some real winners, but also a lot of losers.

Lamonica: Yeah. No, exactly. And as I said before, I don't think my competitive advantage is analytical, meaning I don't think I'm going to be able to do a better job than other investors picking those winners. The other thing about emerging hyped industry is that valuations are often really high. So, you have these companies that are priced for perfection in industries that may or may not play out. Sometimes you can make a ton of money, but most investors tend to not do as well in these situations.

Jayamanne: Okay. So, what else do you look for?

Lamonica: Well, as I've talked about before, once again along with the boring side of things, I like dividends. So, I'm looking for companies that pay dividends and they have a history of raising those dividends. I also like companies that have manageable levels of debt. And finally, I like companies with moats because over the long term, which is how I'm trying to invest, those advantages continue to accrue to investors.

Jayamanne: And American Tower fits all the criteria. Our analyst assigns a narrow moat to American Tower. They pay dividends and have managed to grow their dividend by a minimum of 20% a year since 2013. So, we've got a great company that checks all the boxes on your list. So, why don't you own it?

Lamonica: Yeah. Well, I've always wanted to, but I've always thought it's been too expensive. So, there are a lot of other people that look at this company and they think they want to own it. So, it never gets particularly cheap. But in the recent market sell-off the price of American Tower has come down.

Jayamanne: So, what's the price that you would buy American Tower, because many great companies are never really on sale?

Lamonica: Yeah. No, that's definitely true. And this is where I need to understand that investing in the current environment is not about finding the market bottom. So, that is really, really hard to do. It's about buying at a level where I'm confident that I'll achieve my financial goals.

Jayamanne: And that's about achieving that 6.9% return. But before we get into that, we can see that on an absolute basis, American Tower is not exactly cheap, but on a comparative basis to where it has historically traded, it could be considered cheaper. For instance, if we look at the P/E ratio, it is trading at a little over 35, which is higher than the overall market, but that level is 37% lower than the five-year average P/E. The dividend yield is around 2.75%, which isn't all that high, but it is the highest dividend yield in more than a decade. And finally, we have our analyst opinion. Our analysts believes that shares are fairly valued and therefore a 3-Star stock. Once again, not cheap, but American Tower hasn't traded at a 3-Star level since 2018 and hasn't been considered undervalued since 2016.

Lamonica: Yeah. No, exactly, Shani. But once again, I want to focus on my goals and that's 6.9% return. So, in order to assess if that is achievable, I need to look at the three ways we get returns from shares as investors. So, why don't you remind everyone what those are?

Jayamanne: Well, you get returns from changing valuation levels. If valuation levels go up and people are willing to pay more for a company that is positive, and if valuations contract and investors are willing to pay less for earnings that is negative. The next source is growing earnings, because if investors are willing to pay the same multiple on earnings and they grow, the share price will go up. Then finally, you have dividends that are paid.

Lamonica: So, let's start with valuation levels. As American Tower is widely acknowledged to be a good company, it is historically traded at a premium to the market. And Shani pointed out, American Tower is comparatively cheap to where it has traded in the past. So, my assessment right now is that, well, I probably can't count over the long-term of getting an uplift from valuation levels. I think perhaps we're getting to a level where we could also not see a long-term negative impact from dropping valuation levels.

Jayamanne: Okay. So, that's neutral and leaves us with earnings growth and dividends.

Lamonica: Exactly. So, let's start with dividends, because that's fairly easy. As you said, we're currently getting a 2.75% yield. So, right off the bat, that is about 40% of the total return that I'm looking to achieve. Plus, historically, the dividend has grown, and I think it's fair to expect the growth to continue in the future. I don't think it will grow at that 20% clip, because frankly that's just unsustainable. But that will, of course, add to my returns overtime.

Jayamanne: So, let's be conservative and just look at that 2.75% yield. That means that you need 4.15% a year in return, driven by earnings growth if you're going to achieve your returns. And if we look historically over the past five years, earnings have grown by 20% a year, and looking forward, our analyst sees revenue growth of mid to high-single-digits over the next five years with margins increasing as well, which will further grow earnings.

Lamonica: Yeah. No, exactly. So, I look at that and some of the opportunities they have for growth internationally, which will lead to revenue growth in the short-term and eventually growth in margin as they add more customers to each of those towers that they're building, and I think that 4.15% is really achievable.

Jayamanne: Okay. So, what are you waiting for here?

Lamonica: Well, honestly, I'm just looking for the share price to take a little bit more of a leg down. As it goes down, it makes it more likely I won't face the return headwinds from falling valuation levels over the long term. And that would, of course, boost the dividend yield, which lowers the earnings growth I would need.

Jayamanne: And do you think that will happen? And what level do you want shares to fall to?

Lamonica: Well, I'm trying not to get too fixated on a number, but ultimately, I would like it to go down into the high $190 range, and it's currently trading at $214. And that level, the 190-range, gives us a dividend yield of around 3%. But it's only one of a couple of opportunities I'm looking at that are starting to get into ranges where I'm interested.

Jayamanne: And we've obviously had a rough go of things lately with the market. Do you think it will keep falling?

Lamonica: Yeah. Well, making predictions is never a good thing because they're never right. But I do feel like the market overall has not gotten cheap enough to signify a bottom. So, right now, we're starting to see analysts cut estimates to reflect the reality of a worsening economic condition. And that combined with what I consider a more realistic view of the actions that central banks will take to control inflation has led to this latest fall. But I do think there's a bit to go. But once again, I'm trying to keep that view separate from the evaluation of specific opportunities, which I'm lining up against my goals. So, this isn't about finding the bottom. It's about finding an entry point that has a high probability of me achieving my goals over the long term.

Jayamanne: So, I'm sure Mark will keep us updated of when or if he starts to invest some of his cash. But I think the important takeaway from this episode is why structure is so important when making investing decisions. And this was a good example of why you need a goal and to know the return needed to achieve that goal, the importance of having self-awareness of what types of investments resonate and the investment approach you're trying to take.

Lamonica: All of that structure will provide you with the basis for evaluating different investment opportunities that is particularly critical in a market environment like this, which can be very stressful for investors.

Jayamanne: And that stress can cause people to make mistakes. And while we all make mistakes, the more we can limit them, the better chance we have of achieving our goals.

Lamonica: So, that's our episode for today. Thank you very much for listening. Last chance – this will be published on Sunday. Our conference will be the next Thursday. So, last chance to join us there. And once again, thank you very much for anyone who has left us comments on their podcast app, especially (Sally) who left us the latest one and also to support the podcast. We'd love it if you supported our sponsor, Janus Henderson.