, at least make sure the work was done.Ask questions. You will find out quickly how thorough your brokeror advisor is.
I remember a time, years ago, when I trained institutional brokersby role playing with them before they pitched an investment storyto a client. | would pretend to be the client, listen to the story, thenask questions. Some of these fellows had spent hours learning theintricate details of some new medical technology and were primed todiscuss this new found knowledge in great detail. But when I askedwhat the company’s sales had been for the last two years, I often gota deer-in-the-headlights reaction. If your broker doesn’t know basics,like the company’s revenues, you can’t trust him with the rest of thedata. For starters, keep a list of questions to ask your broker or advisorwhen he or she comes around to pitch the next Microsoft to you.
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Questions to ask your broker about anyrecommended company:
e Revenues
What are the company’s sales?© Growth rate of revenues
How fast have sales been growing?e P/E
What is the price-earnings ratio of the company based on itsanticipated earnings? How does that compare with other com-panies in its industry?
© Market cap
What is the market capitalization of the company. Is it too small(or too large) for my portfolio?¢ Gross margins
What are the company’s profit margins? How do they compareto those of peer companies in the industry?© Debt ratio
How much debt does the company have? How does this com-pany’s debt ratio compare to its peer group?¢ Management
How long has senior management been with the company? Haveyou (or your research analyst) spoken/visited with them? Howrecently?
© Competition
What are the barriers to entry into this business? Who are themajor competitors? Has the analyst spoken with the competition?¢ Timeliness
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What was the price of the stock when the brokerage firm firstrecommended it? (It should be on the report. You don’t want tobe the last person on the list that he called.)
If your broker knows most of the answers to these questions, thenyou can probably take him/her seriously.
Here are other criteria to guide you, based on the advice of theGurus.
Pick a style v This is very important. As we have seen, almost allof the Gurus have chosen a specific style of investment that he or sheis comfortable with. They don’t bounce from style to style, each choseone and stayed with it. You should do the same. This is a very personalchoice. It depends on the type of person you are. Did you identifywith any of the great managers in the book? Do you see yourself asa latent Michael Price, Mario Gabelli, or Laura Sloate? Then youshould probably go the value route. Did you like the approach ofFoster Friess, Richard Driehaus, Bob Gillam, and Scott Johnston? Youare probably more oriented to a growth or momentum style, but ifyou go the momentum route, be prepared to spend a lot of time at it.How about Eric Ryback? His is a nice safe approach with a valueorientation. Perhaps you identified with the way he operates.
Then there are the academics, and for our purposes, I will lumpRex Sinquefield in with them. Did they make sense? In that case,forget about selection entirely; save your time, and buy index funds.(More on this in the next chapter.)
Follow your style ¥ Did you pick growth? Here are the attributesto look for in the companies you select:
© Attractive industry fundamentals
Growing industryDominant or emerging position in the industry© High rate of earnings and sales growth
Industry growth twice as high as the economy’s growthCompany’s growth among the highest in the industry© Reasonable price-earnings ratio
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P/E should not be much higher than the growth rate, e.g. ifgrowing at 20%, than a stock price 20 x earnings is okay.© Strong management
Demonstrable accomplishments either at this company or a priorone.Perhaps you felt more comfortable with the value approach.Here are your selection criteria:
© Low price-earnings ratio (or no price-earnings ratio if thecompany isn’t making money)
© Left behind by the market
A neglected or cyclical industry that may be on the verge of aturnaround.A company with a troubled past that now has new management,new capital, a new product, or a nice combination of these.Sells at a discount to book valuee Hidden assets
Perhaps the company owns Manhattan, which it acquired fromthe Indians, but, following good accounting practice, is carryingthe purchase on its books at cost, $24.
¢ A catalyst factor that will cause the stock price to rise.
You must also choose your size parameters. Are you more comfort-able with small stocks? Large stocks? Small stocks are more exciting,but they entail greater risk. You'll have to decide that.
A final word about picking a style. If you are going to pick stocksyourself, let me at least get you to agree to one thing. You won’t be-come an expert in all the different styles. That is one of the greatfallacies of most of the investment advice you have read. The authorsexpect you to be good at picking all kinds of stocks - growth, value,large and small. Now why is it that they expect you to do somethingthat most of the Gurus don’t even try to do? Don’t even try to becomean expert in everything! If you are going to pick your own stocks, atleast find out what you are likely to be good at, and stick to it.
But that creates another problem. If you become expert in one area,you aren’t likely to wind up with a style-diversified portfolio, some-
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thing that I recommend you do. Given the choice, I would much ratheryou own both growth and value stocks, and also small-cap and large-cap stocks. It is this diversification that will see you through difficultmarket periods while allowing you to participate in the growth ofequity values over time. So how do you solve this problem?
Pick the style that you feel you are most likely to excel with, givenyour personal preferences and talents, then turn to outside help forbalance and diversification. Don’t try to do it all yourself.
In the next chapter, I will suggest specific asset allocations forspecific types of risk. Whenever possible, we will use the actual fundsmanaged by the Gurus we have interviewed.
When do I sell?
Most professional investors will tell you that deciding when to sella stock is much harder than deciding when to buy it. For that reason,many Gurus use formulas, or benchmarks, which virtually take thedecisions out of their hands. Perhaps that’s why the factors that gointo a sell decision are often referred to as the manager’s “sell discip-line.”
For some managers, selling based on a formula makes the task alot easier. Certain small-cap managers, including a few of our Gurus,sell when a company becomes too big to be considered a small-capcompany. Other managers and investors set specific price objectives.They may, for example, decide that a 30% increase in the price of astock over a defined time period is ample reward and that any object-ive beyond that would be greedy. Conversely, these managers mayhave a discipline to limit their losses. If a stock declines by a certainpercentage, they’re out. Momentum managers, on the other hand, willstay with a stock as long as it is moving in the right direction - up!
As you can see, there is no easy answer to the question about whento sell a stock or even a mutual fund. In order to arrive at our ownintelligent sell discipline, let’s start by applying the process of elimin-ation.
First, let’s agree that we are all investing for the long term, that is,a minimum of three to five years. This is important for a very simplereason: no one has yet come up with a consistent way to predict stockprice movements. Yes, one or more prognosticators will get lucky andcall a major turn in the market, like the crash of 1987, but how many
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do you know who have been able to do that two or three times? Don’teven bother looking. Thus, the first sell idea we should eliminate ismarket timing. We are not going to sell our stocks or funds becausesome market prognosticator decided that the market was headed fora slide. Even if he or she is right, will they be there to tell us whento get back in? Not likely. The advice you have heard to stay investedis good advice.
When do we sell? Is it wise to set a specific investment gain object-ive and sell when it is reached? You can’t go broke doing that. Onthe other hand, you will miss those ten baggers Peter Lynch talksabout, stocks on which you might make ten times your money.
Here’s the soundest advice I can give you about selling. First, inthe case of a mutual fund, you should consider selling if the Guruwho manages your fund, and who might have been the reason youbought it in the first place, decides to change jobs or go fishing forlife. The manager might possibly be replaced by another good one,but you won’t know that right away. You might want to sit on thesidelines and observe for a while.
Another reason to sell a fund is if its objectives change. If yourgrowth fund starts to act like a value fund because the manager de-cided he likes value stocks, then you no longer have a growth fund!Find another one. Finally, if the fund’s performance over time (oneyear or more) deteriorates below both the fund’s past performanceand a suitable benchmark (S&P 500 for a market-like fund, a growthstock benchmark for a growth fund, etc.), it may be time to partcompany and find a new fund.
For stocks, my favorite sell discipline is to apply the same criteriaI used to buy the stock in the first place, only in reverse. Have thefundamentals of the company changed for the worse? Is the price ofthe stock no longer reasonable based on the criteria I used to buy itoriginally? Is the business still sound? Has the competition caughtup to my company? In other words, if I can no longer find goodreasons to buy the stock, at its present price, then maybe it’s time tosell.
This technique also applies to the decision to sell at a loss. Thereare two ways to look at a loss. First, you might decide that if a stockdeclines 15% or more, no matter what the reason, you want to getout and cut your losses. I prefer to use a less mechanical approach.Once again, I evaluate what may have changed to cause the decline.
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If the stock is going down because the market is declining, that is nota reason to sell it. But if new factors have cropped up, and you wouldnot buy the stock at its present price, consider getting out, even at aloss.
It amazes me that some investors make sell decisions based onwhether or not they have a profit or a loss. These investors will simplynot sell a stock at a loss. They just don’t want to admit they made amistake. Don’t be like that! Whether you have a profit or a loss isimmaterial to your investment decision. Behave rationally! This advicenotwithstanding, and human nature being what it is, even if you de-vise your own sensible sell discipline, you will probably do what mostof us do: the day after you sell that stock or fund, it will be the veryfirst name you look up in the paper the following morning!
Should we invest in stocks ourselves or letsomeone else do it for us?
Well, if you are an investor who wants to select your own portfolio,you may not like what I am about to say. Should you, or should younot, pick stocks yourself? I know there’s a lot of helpful advice outthere. There are thousands of stockbrokers eager to get some of yourattention, and a lot of your money, in order to share with you thecombined wisdom of their own “expert” views plus those of their re-search departments. The research budgets at top Wall Street firmsexceed $50 million per year, so you’d think they must be doingsomething right. I wish I could be sure of that, but I’m not, although,some research departments are better than others.
If you don’t want to listen to some broker with a good story, thereare always the newsletters where, for a paltry hundred bucks a yearon average, you'll benefit from the wisdom of their top picks. Theseoften come from some of the top seers in the business.
And don’t forget the books, the countless books which purport toshow the true path to investment wisdom along with a nearly fool-proof way to pick stocks. How good are these books? Probably asgood as the last diet book (or investment book) you bought. Hey, ifthey worked, we wouldn’t still be buying them, would we?
Remember Driehaus’ story about the piano virtuoso? To become avirtuoso, and have people pay to listen to you play, you have to be
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very talented, to be sure. But you’ll never make it to Carnegie Hallwithout a strict and grueling regimen of practice, practice, practice.I know you'll agree with that.
Let’s take another example. Let’s assume you are a very smart per-son, a fact which I do not doubt for one minute. Suppose you, andsomeone just about as smart as you, decide to become, say, jet pilots.Your friend, however, decided to keep his job as a nuclear physicistand you chose instead to give up your lucrative heart surgery practiceand devote all of your time to learning to fly. You went through everycourse, every training program, flew eight hours a day and also mostweekends. Your friend did the minimum coursework, flew wheneverhe had the time, and barely managed to get his license. After a yearor so, who would you rather go flying with?
Now let’s bring the analogy home. You follow the market, you liketo do some research on companies, although admittedly it’s prettybasic research, and from time to time you decide to buy a stock, eitherbecause you uncovered it yourself or someone sold you a great storyabout the company. Do you believe that your likelihood of investmentsuccess is going to be as good as someone who is just as smart asyou (or dare I say, smarter?) who spends all of his or her time man-aging money? The amateur versus the professional? Forgive me, butI don’t think so. It’s hard enough to be good at this business, whichis why this book features only a handful of Gurus out of tens ofthousands of professionals. Sure there are other Gurus, but the pointis the same, isn’t it? I’m sticking with the odds.
Does that mean you can’t possibly do well on your own? Of coursenot. It’s just a question of how much time and effort you are willingto put in it. And you must be honest with yourself about this. I profferthis advice with some trepidation. For one, whether or not you agreewith me, at least give me credit for not pandering to you the waysome other books and articles do so shamelessly. They will make youbelieve that you, the amateur investor, are going to have as muchsuccess investing as some of the top professionals. And even if youdo invest yourself, what are your odds of winding up in the top tierof investment manager performance? What if, instead, you tried tofind those investment managers or mutual fund managers who mightbe likely to wind up in the top tier? It’s your money.
So, my recommendation is that you not take up part-time jet air-
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plane flying, that you not manage the bulk of your assets yourself,and that, in both cases, you get professionals to do the job for you.
Did I hear you say you still want to invest for yourself? Okay, let’stalk.
I realize perfectly well that some of us invest not only for profitbut also fun. Nobel Prize winner Merton Miller, who is basically anefficient market theorist, told us he, too, takes fliers in stocks. It’s justsomething we enjoy doing, a process of investigation, discovery, andultimate reward through profit. If I haven’t discouraged you by now,well, you are probably destined to go ahead and do it, so do it right!All I ask is that you do it with a limited percentage of your total assets.
My contribution to the exercise is to provide the guidelines for youto follow. Refer to the Gurus as often as you can. Repetition helps.As you continue your quest for the next stock on which you'll maketen or twenty times your money, read through some of the summarycriteria we learned from the very best of the managers.
Here’s my bottom line: you will succeed if you are serious aboutputting in the time and effort. Please remember, there are no shortcuts.It’s about work, not luck. If you’re a lucky person, play the lottery.
348CRAFTING AN INTELLIGENTPERSONAL INVESTMENT PLAN
I used the word “intelligent” in the title of this, our last chapter,for a reason. I want you to distinguish what you are doing from theinvestment blather and hoopla from so many other sources. Forgetall those promises of instant wealth from stocks, thousand percentreturns, and tempting penny stocks that will make you a fortune, andall the rest. I don’t have to tell you where all this comes from. Youprobably know as many sources as I do. By now, you also know whatdoesn’t work. Our job, yours and mine, is to concentrate on whatdoes. Our objective is to create wealth intelligently, with all the oddsin our favor.
The next thousand years is just around the corner. All of us willretire by some time in the first century of the next millennium. Thequality of our retirement years will directly depend on the investmentchoices we make along the road. For many of us, our material well-being long before retirement will be a function of the financial choiceswe make at different life stages. Whatever your age, there is a won-derful opportunity staring you in the face. You now know thatthroughout recent history, the stock market has delivered the bestinvestment returns of all asset classes. You learned new techniquesfor analyzing risk and returns from the Nobel Prize-winning econo-mists who devised them. You visited with investment Gurus who de-liver top-of-the-class investment results.
Now it is time to put what you have learned into practice.
Before we apply our investment crafting tools to a specific portfolio,we must establish some basic parameters. The first two are your ageand your time objective. Of course, at some point in our lives, we willbe putting aside money for retirement, the earlier the better. But re-tirement is not everybody’s immediate objective. There are homes tobuy, children to educate, fantasies to indulge, and they all have onething in common: they cost money. If you are young and have smallchildren, you already know how expensive it is going to be to putthose kids through college. Personally, | am staggered when | readabout the costs of educating our children. When I went to Georgetown,PETER J. TANOUS
it cost something like $2,000 a year for everything. Two of our threechildren have since graduated from that same school. The cost wasrecently running about $25,000 a year. So, if your kids are young...it’sfrightening, isn’t it?
Before you even think of retiring, perhaps your shorter term goalis a red Ferrari, an oceanfront home in Florida, or a lodge in Aspen.(Let's skip your other fantasies for the moment.) We both know thatyour passbook savings account isn’t going to get you from here tothere. The good news is that you are young and the really good newsis that you have just received advice from perhaps the greatest invest-ment minds in America. Remember, your investment time frame isan important component to your investment strategy. The longer youhave, the higher the odds you will achieve your goal. So if the kids’college days are ten years in the future, you may want to invest moreaggressively than you might otherwise. If your son or daughter is inhigh school, I hope you already have a nest egg for college. In thiscase, you may need to invest that money more conservatively, becauseyou will be spending it in a few short years.
Retirement money, in your 401(k) or IRA, should be approachedthe same way. Are you in your forties or fifties? When do you planto retire? At 59, 65, or later? Most of us know individuals who enjoyedfirst-rate pension plans throughout their lives. They managed to retirewith the very same incomes they earned while working. I hope youare one of them. Today, we view such plans as both a bonanza andan oddity, since there are precious few of them around any more. Inthe future, your wealth - retirement and otherwise - will probably bea function of your skill and foresight in planning your own invest-ments, more than likely through your IRA or 401(k) plan. Alas, theera of lifetime employment and munificent pensions is over.
But the news needn’t be all bad. If you start your investment pro-gram early enough, you will be faced with a pleasant dilemma -whether or not to retire at a very early age, continue your presentcareer, or embark on a totally new activity, secure in the knowledgethat a comfortable nest egg will ensure financial viability for the restof your years. Look, I know that if you are under 50, the idea of re-tirement seems so remote that you don’t even want to think about it.Okay, don’t think about it. Just think about building wealth to useany way you want while you're still young enough to enjoy it.
The point is, no matter what your age, now is the time to get started.
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What better way to embark on a new or revised investment programthan after having enjoyed the advice and wisdom of some of thegreatest investment minds of this century?
Your risk tolerance is another parameter. This is really tricky sincemany of us think we know what our risk tolerance is, but don’t really.I can’t count the number of times in my own business that a clienttold me his or her risk tolerance was high; they were investing forthe long term, after all, and we all realize that short term marketfluctuations are unpredictable and unavoidable, so just please findme some Gurus who make 20% a year consistently. Please.
You know what happens, of course. As soon as one of their man-agers has a bad week, the phone rings off the hook. What’s wrongwith him? Didn’t you tell me how good he was? Do you think we’regoing into a bear market? Why did my manager sell XYZ at a loss?Hello? Remember our discussion about the long term? So it goes.Clearly, risk tolerance assessment is better performed by a psychologistthan an investment advisor. But we try.
My advice to you is that you be brutally honest with yourself aboutrisk. It’s amazing how no one seems too concerned about risk whenstocks are going up. Our memories are very short. Can you reallystand a paper loss of 15% or 20% or possibly higher? That’s quitepossible with an aggressive portfolio, you know, including the oneyou might put together yourself. The bottom line is that you mustsettle on an investment strategy you genuinely can live with. If youcan’t live with it, it won’t work. Period.
In this chapter, we utilize the knowledge we garnered from theGurus to arrive at guidelines which will give direction to your futureinvestment decisions. These are practical, sensible, time-testedguidelines which you should follow seriously. You may have heardsome of this advice before. That’s good. It means that some of theadvice you got wasn’t all bad. But as with fine cuisine, it is not justthe ingredients, but the combination of ingredients, that creates greatdishes. Likewise with your investment portfolio.
In this chapter, we will construct some sample portfolios using themethods employed by the most sophisticated institutions to maximizereturn and manage risk. We will make use of the Nobel Prize winners’techniques, as well as some time-tested performance enhancingtechniques employed by the great investment Gurus we encounteredalong the way. To make the examples more vivid and practical,
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whenever they fit our framework, we will use the actual mutual fundsmanaged by the Gurus with whom we spoke. We will not recommendthose Gurus who are private money managers because most of themhave minimums that are so high, few readers will be able to employthem directly. (Laura Sloate, however, is available through SmithBarney’s consulting division, with a $100,000 minimum.) For thosefortunate few, the same principles of selection we use to select fundscan also be applied to the great money managers.
We illustrate both conservative, and more aggressive, strategies.Most importantly, the strategies can be tailored to your specific risktolerance and needs using the very same funds, but in differentcombinations. This will be clear in a few minutes.
An important point. You no doubt know that many long termportfolios consist not just of stocks, but of stocks and bonds. Wedidn’t talk much about bonds, did we? In fact, the only Guru we en-countered who was interested in fixed income securities was EricRyback of the Lindner Fund. Our primary reason for ignoring bondsis that we spoke with investment Gurus who are equity managers.That’s where the performance is.
Historically, bonds were used by portfolio managers in bank trustdepartments to create ballast in a portfolio. The idea was that yourbonds would provide stability and income, and help you weather anystorms in the stock market, or so the theory went. My, how timeshave changed! While there are still an awful lot of portfolio managerswho believe that conservative accounts should be invested 60% instocks and 40% in bonds, most modern managers are aware of thenew realities of the marketplace. In recent years, long term bondshave proven to be as volatile as most stocks, causing gyrations inmarket values that would get a momentum manager’s attention. In1994, for example, the “long bond” (30-year treasury bond), declinedover 17%. Even after you take into account the income you receivedfrom the bond, you were still down over 10%. That’s safety? It is oftensaid that more money was lost in bonds in 1994 than in stocks in the1987 crash.
What does this mean to modern portfolios? Just this. If you wantfixed income for stability, for God’s sake, don’t buy long term bonds!Buy short term (up to five year) instruments. Shorter maturities don’tfluctuate as much with changing interest rates, since you get all ofINVESTMENT GURUS
your money back as soon as they mature. We will show a few ex-amples of portfolios with some fixed income securities.
Frankly, there is an interesting case to be made that you shouldn’tuse bonds at all in any portfolio, even a conservative long termportfolio. No one has made this case more brilliantly than guru PeterLynch. In the September, 1995, issue of Worth magazine, Peter wrotea cover story entitled “Fear of Crashing,” which offers compellingevidence for staying in stocks through thick and thin. In my opinion,it was a superb piece of analysis. Check your local library or callWorth magazine in New York to get a back issue.
Another important point. We didn’t speak with any internationalequity managers this time around. However, I believe that it is import-ant for you to consider including some international stocks in yourportfolio simply because, today, almost two-thirds of market capital-ization is outside the United States.
An important reason to own international stocks is our FANCY-EXPRESSION-OF-THE-DAY: Non-Correlating Asset Class. Try thatout at the gym. As you might expect from all we have learned, youwill want your portfolio to be diversified by style (growth versusvalue) and also by size (large-cap versus small-cap). In so doing, youwill achieve intelligent diversification along those areas of risk whichhave been identified in the market.
But there is yet another way you can diversify risk, and that is byowning foreign stocks. Stocks in foreign countries tend to behavedifferently than American stocks. In other words, their performancedoes not correlate with the performance of American stocks. Back toour fancy expression, non-correlating asset class. You diversify riskif your types, or classes, of securities do not correlate well to oneanother. That means, to put it very simplistically, whatever makesyour American growth stocks move one way, is not likely to moveyour foreign stocks. Thus, having a group of stocks in your portfoliothat behaves differently from other classes ought to give you anotherelement of stability.
By combining great managers with our heightened knowledge ofhow markets work, we should go a long way toward having a trulyintelligent portfolio that delivers what we expect with a minimum ofsurprise.
By now, you ought to be asking whether I’m going to come downon the side of the Gurus who recommended we go passive, that is,
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not even try to beat the market, since so few managers do. Or will Iopt for the Gurus who have proven that over time they can, in fact,beat the market? I’m going to recommend both.
Did | just hear the word “cop-out”? Harsh, my friends. Hear meout. The fact is that it is indeed very, very difficult to beat the marketover long periods of time. We happen to have identified some of thegreats who have done so, and who, we expect, will continue to out-perform their peers. But we also ought to play the odds a little bit.How? By having a portion of our assets in intelligently diversifiedpassive funds whose performance over time has been more predictablethan that of any specific active manager. How much will we have inpassive investments, you may ask? That is, in part, a function of yourrisk tolerance.
Likewise style and size. Do we want to bet the ranch on growth?Or maybe small-caps? I don’t think so. What we want to do is toparticipate in all of these styles and size attributes since they tend todo well at different times and at different stages of the market. Thatis intelligent diversification. Having 50 growth stocks is dumb diver-sification.
Let’s get started.
The way we are going to approach portfolio construction is to usethe best data available to us to “back-test” different combinations ofstrategies and see what works and what doesn’t. Why do we back-test? Because unlike so many of the great prognosticators on WallStreet, on TV, and in newsletters, we admit to a humbling failing. Wecannot predict the future. Given this handicap, we will analyze whatworks, at least historically. In so doing, we will be able to select greatcombinations with the advantage of hindsight. No losers here! Soplease always bear in mind that in making recommendations in thismanner, we are benefiting from what is known as “ex post bias.” Putanother way, it’s real easy to win at the races when you already knowwhich horses won.
Why do this at all? Because history tells us some interesting things.We know, over periods of time, how certain classes of securities be-have, the longer the time period the better we are able to assess thepattern. We have also spent time identifying those rare investmentmanagers, the Gurus, who have something extra, that something thatallows them to consistently beat the market. Here again, the longerthey’ve been able to do it, the better. This becomes our learning
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laboratory. These are the people we want to analyze and emulate.These are the Gurus we want to use.
I mentioned we would use a combination of active and passivestrategies. Passive management means more than just buying a marketclone, like an S&P 500 fund. But we will use that index as a bench-mark. Today, passive strategies are very sophisticated. Remember theinterview with Rex Sinquefield? His firm, Dimensional Fund Advisors(DFA), offers dozens of passive funds from which interesting combin-ations of asset classes can be created. We will use some of them. Ishould point out that DFA funds are only available through financialplanners and advisors, but there are plenty of those around. Forreaders who prefer to do it themselves, we will also use some Van-guard index funds in our examples. These funds can be purchaseddirectly and are very cost-effective.
For active funds, we will use the mutual funds of our Gurus but,of course,