How I Beat the Market — Tripled It, in Fact — Over the Past Decade

• Things that are fragile — or break easily when stress is applied. A porcelain cup would be a good example. 
• Things that are robust — or are pretty much unchanged by stress. A simple piece of iron would be robust.
• Things that are antifragile — or that actually get stronger when stress is applied. Our muscles — which get micro-tears when we lift weights and then grow back stronger — are an example most people can understand.

Unconsciously, I had been aware of the first two. The third was a revelation. I took the broad ideas from the book and started applying them to how I picked companies to invest in.

Before this, I tried to predict which companies would be the most successful by creating a narrative about their future. That didn’t turn out so well. The stock market doesn’t care about the stories in my head.

After reading the book, I wanted to look for factors that were clearly measurable. And I wanted those factors to be the type of things that would tip the scales in favor of companies not only surviving tough times, but getting stronger because of them.

With that as a backdrop, here are the three factors — in reverse order of importance.

<h2 class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Skin in the game” data-reactid=”64″>Skin in the game

In the time of the Babylonian king Hammurabi, people wanted to build bridges. But they weren’t willing to fork over money to a bridge builder who may not have been on the up-and-up.

To mitigate this risk, the bridge builder was forced to sleep underneath the bridge. What better way to guarantee the best construction: no paperwork, legislation, or background checks necessary. The bridge may fall, but if it did, the bridge builder would go with it.

In essence, this is the principle of skin in the game: the best way to get a fair deal is to make sure all parties have incentives that are aligned. In investing, this means I look for three things:

• Founder-led companies: Because founders often view their company as a natural extension of themselves, they are intrinsically motivated to create something of lasting value.
• High levels of stock ownership: If those intrinsic motivations aren’t enough, I want to know management will only prosper if I — as a shareholder — prosper as well.
• Outstanding Glassdoor employee reviews: While it’s not a perfect system, you can get an idea for how satisfied employees are working at a company. Anonymous reviews are submitted, tabulated, and posted for all to read at Glassdoor.com

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="You can check the first two by using the SEC’s Edgar database, typing in a ticker symbol, and looking for the most recent proxy, or DEF 14A filing. The third you can check by visiting Glassdoor.com, clicking on "Company reviews," and filling in the name of an organization.” data-reactid=”72″>You can check the first two by using the SEC’s Edgar database, typing in a ticker symbol, and looking for the most recent proxy, or DEF 14A filing. The third you can check by visiting Glassdoor.com, clicking on “Company reviews,” and filling in the name of an organization.

If we look at the five most successful investments I’ve made over the past decade, they all share some of these characteristics.

Data source: Company proxy filings, Glassdoor.com. Ownership data accurate as of last DEF 14A filing. Glassdoor ratings accurate as of Aug. 9, 2019. *Includes only ownership by Lutke. 

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Combined, these five stocks have returned 520% for my family — sextupling their original investment. Unfortunately, however, skin in the game alone is not enough to tip the scales in my favor. Case in point: My investments in&nbsp;GoPro&nbsp;and&nbsp;Fitbit&nbsp;incurred huge losses even though both companies were founder-led, had high levels of insider ownership, and enjoyed moderate-to-strong Glassdoor reviews.” data-reactid=”77″>Combined, these five stocks have returned 520% for my family — sextupling their original investment. Unfortunately, however, skin in the game alone is not enough to tip the scales in my favor. Case in point: My investments in GoPro and Fitbit incurred huge losses even though both companies were founder-led, had high levels of insider ownership, and enjoyed moderate-to-strong Glassdoor reviews.

That’s why there’s more to this technique than skin in the game alone.

<h2 class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Financial fortitude” data-reactid=”79″>Financial fortitude

The next thing I want to check is a company’s financial fortitude. Specifically, there’s one simple litmus test I want to consider:

If there were to be a crisis — on par with the Great Recession — tomorrow, how would it affect the company?

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="While the&nbsp;stocks&nbsp;I’m invested in would probably go down, I am more concerned with the&nbsp;business&nbsp;and its long-term health. That’s because companies with lots of cash, little debt, and strong cash flows can actually get stronger&nbsp;because of a recession. How? They could” data-reactid=”83″>While the stocks I’m invested in would probably go down, I am more concerned with the business and its long-term health. That’s because companies with lots of cash, little debt, and strong cash flows can actually get stronger because of a recession. How? They could

• acquire start-ups at a discounted cost.
• buy back its own shares at lower prices.
• undercut competition on price — losing money in the short term, but gaining market share in the long term as the competition goes under.

There are three very simple metrics I consult when evaluating financial fortitude: cash (including investments), long-term debt, and free cash flow. Using those same five companies as examples, here’s where they stand.

Data source: Yahoo! Finance.

Admittedly, these comparisons are a little weird: Amazon is orders of magnitude bigger than Paycom, for instance. But there is a clear general trend: All of these companies have more cash than debt, and they all have positive cash flows.

Again, however, this alone isn’t enough to make a stock a buy. Back in 2015, GoPro generated $107 million in free cash flow, and it ended the year with $474 million in cash and zero long-term debt. 

Since then, the stock has lost 75%! The final section will help explain why.

<h2 class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="The barbell approach” data-reactid=”95″>The barbell approach

When most people think of a barbell, they think of a long bar with equal weights on either side. This isn’t a perfect analogy, because the barbell approach calls for:

• Dedicating at least 80% of your resources to a safe and reliable investment.
• Dedicating the other 20% to high-risk, high-reward ventures. Most of these ventures will fail, but when one “hits,” it can be a huge success.

At the companies I invest in, I look for this type of dynamic. In general, it looks like this:

• Safe end of the barbell: reliable and repeat business that’s protected by an easily identifiable moat.
• Risky end of the barbell: evidence of tinkering with new products, including previous “big hits.”

Let’s deal with the first of those two bullet points. When evaluating moats, it’s important to understand all the forms they come in. I like to think of moats as existing in four different buckets.

1. Network effects: Present when each additional user of a product or service makes it more valuable to all other existing users. Facebook is the most obvious example of this moat. The site wouldn’t be worth anything if your friends weren’t on it.
2. High switching costs: This happens when changing from one company to another incurs high financial, emotional, or logistical costs. The most obvious example from most people’s lives would be switching banks. With all of the connections you have — paying credit cards, direct deposits, etc. — leaving your bank can be a headache.
3. Low-cost production: If one company can produce something at a consistently lower price than others, while having the same baseline quality, it will always win business. Alphabet — parent company to Google — is able to produce data for advertisers at a lower cost than just about anyone thanks to its search dominance.
4. Intangible assets: These include valuable brands, (think Apple), patents (think pharmaceuticals), and government-regulated protections (think utility companies).

Without diving too far into the weeds, here is a summary of the most important moats for each of the five companies mentioned above.

To be sure, this isn’t an exhaustive list. One of the reasons these companies have fared so well is that they are protected by multiple moats. Hopefully, though, you get the idea: A company needs to be dominant in its main line of business to secure the “safe” side of the barbell.

Incidentally, it is here that Fitbit and GoPro failed: They were both protected by weak moats — brand value. Anyone can make a fitness watch or camera. It’s easy to switch these products, there are no network effects, and neither company had a low-cost advantage.

But now, let’s focus on the second half of the barbell: high-risk, high-reward ventures. It might seem like a waste to spend 20%-ish of your resources on projects that will probably fail. But if even one of those projects does well, it can change the entire trajectory of the company.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Mercadolibre is a case in point. Ten years ago, the company's payment system — MercadoPago — was an afterthought. Its marketplace was the real focus. But in just the past three years, MercadoPago has taken off. It’s the key catalyst behind the stock’s doubling in 2019 alone.” data-reactid=”116″>Mercadolibre is a case in point. Ten years ago, the company’s payment system — MercadoPago — was an afterthought. Its marketplace was the real focus. But in just the past three years, MercadoPago has taken off. It’s the key catalyst behind the stock’s doubling in 2019 alone.

Mercadolibre, however, isn’t the only one testing such ideas. Here’s a look at some of the other high-risk, high-reward ventures at the other four companies.

The bottom line: These companies aren’t resting on their laurels. They are actively looking for new ways to make their customers’ lives even better.

<h2 class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="A final word on stock picking” data-reactid=”121″>A final word on stock picking

This is by no means the only way to pick a market-beating portfolio. It may, in fact, not even represent a method of investing that will produce great results going forward.

Of course, you can borrow freely from this framework for your own investing. But the larger point I’d like to drive home is this: create your own framework. Start with small sums of money and review what’s working and what isn’t. As you gain more confidence, add more money. Over time, you might be surprised by how well you do.

And that success can provide your family with life-altering financial flexibility as well.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="More From The Motley Fool” data-reactid=”125″>More From The Motley Fool

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool’s board of directors. Brian Stoffel owns shares of Aflac, Alphabet (A shares), Alphabet (C shares), Amazon, Facebook, MercadoLibre, Paycom Software, Shopify, and Veeva Systems. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Facebook, Fitbit, MercadoLibre, Paycom Software, Shopify, and Veeva Systems. The Motley Fool recommends Aflac. The Motley Fool has a disclosure policy.” data-reactid=”133″>John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool’s board of directors. Brian Stoffel owns shares of Aflac, Alphabet (A shares), Alphabet (C shares), Amazon, Facebook, MercadoLibre, Paycom Software, Shopify, and Veeva Systems. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Facebook, Fitbit, MercadoLibre, Paycom Software, Shopify, and Veeva Systems. The Motley Fool recommends Aflac. The Motley Fool has a disclosure policy.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="This article was originally published on Fool.com” data-reactid=”134″>This article was originally published on Fool.com