From the Editor - June 05

The commentary below is from our monthly newsletter and is provided here as a convenient reference for our readers.

Our Investment Principles

Last month we discussed some of the rules that are used in the stock selection process for The Prudent Investor’s Model Stock Portfolio (Table 2). Assuming that our longer-term performance is not based on luck, you are probably interested in knowing what goes into our picking a basket of stocks for investment purposes.

We mentioned last month three key principles to follow in good stock selection:

1. Follow the insiders.
2. Don’t overpay for a stock.
3. Never buy a stock unless you know its “sell” price.

We next look at five additional investment principles that The Prudent Investor follows:

1. Use a reliable asset allocation model. Almost every investor has heard of the concept of “asset allocation,” which is a glorified way of saying “don’t put all your eggs in one basket.” The most basic asset allocation model will tell an investor how much of his hard-earned cash to put in fixed income (e.g., bonds) and how much to put in stocks. What most people do not realize is that asset allocation is a relatively newer discipline. The concept of diversification has been around for thousands of years—King Solomon even wrote a bit about it (e.g., Ecclesiastes 11). However, asset allocation as a formal methodology for allocating investments is newer and, in a sense, less “proven.” Our Asset Allocation Models shown in Table 3 follow a quite simple, yet robust, method for determining a reasonable mix of stocks and bonds. The model we use is commonly called the “Fed model” (so named because it became a guide for federal reserve chairman Allen Greenspan not long after he uttered the now-infamous declaration that the market was displaying “irrational exuberance”—turns out that after he declared the stock market to be insanely overvalued, his newly adopted “Fed model” suggested that it was about fairly valued at the time of his statement after all). The Fed model does not attempt to make predictions about the future of anything; it merely attempts to suggest whether stocks are currently over- or under-valued relative to fixed income. As it turns out, this simple model has been amazingly useful in alerting investors to whether the stock market is in the danger zone or not. It is important for any investor to have a credible model for determining how to balance the mix of stocks versus cash/bonds. For more information on the Fed model, you might wish to view the following document published by Ed Yardeni, a vocal advocate of the model: http://www.yardeni.com/pub/valucb.pdf.
2. Don’t water down your best ideas. Most investors bypass picking individual stocks and select a basket of mutual funds for their investment. While this is a valid strategy (especially when following an asset allocation model such as that given in Table 3), what more commonly happens is that investors will choose two, three, or more mutual funds that have that same style/strategy (e.g., “aggressive growth”) that are offered by different mutual fund companies. A typical equity mutual fund will own 100-300 stocks. If an investor buys three similar mutual funds, they may indirectly own several hundred stocks. What happens is the investment return ends up being close to the average return of the market—after all, it’s hardly possible that all, or even most, of those several hundred stocks are going to deliver above-average returns. At The Prudent Investor we intentionally limit our selection of stocks to between 20-25. The result is that if or when we identify a stock that is truly above-average in its growth potential, our pick is not watered down by dozens (or hundreds) of other less attractive stocks that do not have the same growth potential. This strategy requires a little more due diligence in picking good stocks, but the research can be rewarded with above-average returns over time. Of course the downside is that the volatility of returns can be higher than the overall stock market. We feel this is a small price to pay for increased performance over time.
3. Reallocate portfolio to force a “buy low-sell high” strategy. The concept of “buy low, sell high” seems so obvious as to be unnecessary to even mention. The sad reality, however, is that most investors do not follow this practice. They allow their emotions all too often to dictate their investment decisions and do precisely the opposite. In fact, emotional investor behavior is so predictable that there is an investment strategy dedicated to exploiting it. Called “contrarian investing,” it operates on the principle that when the market is at its gloomiest, when no one thinks the market is going to go up again (at least for an extended length of time), that’s when the contrarian investor should buy. At The Prudent Investor we use a proprietary model that automatically calculates each month the ideal investment allocation for each stock (called “Target Ownership” in Table 2). While we are reluctant to divulge the details of our own model, you can easily construct a simple model on your own to help enforce the discipline of “buy low, sell high.” To illustrate, consider a very simple model: if you own a portfolio of 20 stocks, set your target ownership at 5% for each stock. When your actual ownership deviates too much from your target of 5% ownership, then buy or sell the appropriate number of shares to bring your actual ownership back in line with your target ownership. Such a practice will force you to take profits when a stock has a big run and will also force you to buy more shares when a stock has tanked. Using such a model helps take the emotion out of investing and increases the likelihood of good returns over time
   
   Finally, we offer two last principles that are worth following as an investor:
    
4. Don’t worry if the company is “boring.” Resist the temptation to chase the “sexy stocks” or the stocks that are always in the news. Don’t be duped into thinking that “tech is in” or “energy stocks are hot,” etc. It’s often the dull, unpopular stocks and industries that bring the best returns over time.
5. Be consistent with your investment strategy. When you develop an investment philosophy and fine tune it into an investment strategy, stick with it. Don’t jump from strategy to strategy. That’s a sure way to generate low investment returns. The book What Works on Wall Street does an excellent job showing that any one of several strategies can deliver satisfactory results if followed consistently over time. The book also shows that no strategy will outperform the market 100% of the time. In fact, it is common that virtually any strategy you select will have down months that could continue for multiple years. Bottom line: carefully choose a strategy for investing your money and then stick with it unless or until you have solid reasons (not emotional ones) to change that strategy.

We hope this has been a helpful summary for you to better understand the principles that help guide the investment decisions you see in The Prudent Investor each month. Happy investing!