An oft-quoted statistic holds that 80% of professional fund managers underperform the market. That's one of the reasons many financial advisers counsel investing novices to park their money in index funds -- because if the pros can't beat the market, how can a small investor have any hope?
Matthew Schifrin, the investing editor of Forbes magazine, had a different idea. He hunted down 10 of the best-performing amateur investors over the past 10 years and asked them how they managed to beat the market when so few others were able to. He has compiled their investing secrets in a new book, The Warren Buffetts Next Door: The World's Greatest Investors You've Never Heard of and What You Can Learn from Them.
Schifrin is the first to acknowledge that these aren't average investors, but they are average guys (they're all men) who have shown extraordinary talents for picking winning stocks. Schifrin believes that while ordinary investors may not succeed as well as his mini-Warrens, they can still improve their stock market performance by following some of the tactics used by these top performers.
"You may never be able to get 30%-plus per year, but if you pay attention to your investments and take the time to research stocks and the market, I do believe you can wring a few extra percentage points out of your portfolio," Schifrin says. "So instead of the 8% everyone says you can expect, you can get three extra percentage points. I do feel that's attainable for the average investor."
Here are 10 investing ideas that proved profitable to some of Schifrin's fortunate investors. But, he notes, not all of them shared the same techniques, and some espoused contradictory views from each other.
1. A concentrated portfolio can succeed. Diversification is the mantra of many investment advisers, but many successful investors concentrate on a small number of stocks. "If you've done your homework and you really understand the stocks that you own, then diversification really isn't that important," Schifrin says. "People diversify so much they diversify their returns away."
2. Buy low debt-to-equity stocks. The percentage should be below 50%, according to Schifrin's stars. These successful investors don't like seeing a lot of leverage on company balance sheets. "We came through the meltdown and saw that companies that were dependent on commercial paper or leverage to survive really dropped fast when the banks stopped lending," he notes.
3. Don't be lulled by dividend payments. A high dividend can often lead you to believe a stock is a good buy when it really isn't, a problem known as a value trap. For example, the bank once known as Washington Mutual paid a high dividend right up until it crashed. "Make sure some catalyst in the future isn't going to make that dividend go away," Schifrin warns.
4. Don't accept company's figures unquestioningly. One of these dedicated investors carefully analyzes all of a company's financial statements, including cash flow, tax credits and operating loss carry-forwards, and tosses out fictitious "assets" like goodwill and brand value. "Be careful to strip out a lot of things that aren't significant earnings-producing assets," Schifrin says.
5. Avoid story stocks. This was one piece of advice about which there was strong disagreement among Schifrin's group, but he recommends it. The idea: Stick to statistical analysis and don't be moved by the hottest chat room gossip. "Don't be swayed because a company has an awesome electronic gadget or device," Schifrin says.
6. Have some kind of sell discipline. The investors described in the book take different approaches to this, but all have a system for determining when to sell. One uses a ratio of intrinsic value -- an adjusted forward earnings estimate multiplied by a conservative market multiple -- relative to price. When a stock's price rises to the point where its intrinsic value to price ratio is below 1.25, he sells. Another simply sells when stocks fall 20% from their high.
7. Seek out promising companies that are undervalued because of temporary setbacks. These investors look for stocks that are mispriced because of irrational selling or buying. A bad news story about a drug trial might slam a company's stock, for example, but not be significant in the long run.
8. Don't get too greedy. While some investors wait until their stocks rise 10-fold before selling, others are content to sell after a few-point gain. The lesson: Take profits. Too many investors ride a stock up, only to ride it back down again. If a stock goes against you, don't hold on: Sell.
9. Seek out companies with monopolies and duopolies. These are companies that have what Warren Buffett calls a moat -- a high cost of entry for competitors trying to muscle their way into the business. Example: Mastercard (MA), Visa (V) and American Express (AXP) own the credit card business, and it's very difficult for new rivals to get a toehold. In the food business, Swiss giant Nestle is hard to beat.
10. Avoid companies with high short interest. When hedge funds are piling into the market betting against a company, there may be a lot of negative information about to become more widely known that could damage the stock. Why tempt fate?
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