Sign up for your 21-day Risk-FREE trial and receive complete access to Next Inning

Five Really Good Decisions

That's all it takes - five really good decisions. Well, actually six - the first is learning to focus on what you know best.

In the Internet world of today there's far more sources for advice than there is advice worth considering. In my opinion, the ratio of good to bad advice has reached monstrous proportions. To pick a good source out of the blue would be about as likely as picking the winning lottery numbers twice in a row. To increase your odds, read carefully and accept only what makes sense. Know before you start, there is no free lunch, no way to trade to fast riches and the odds of a penny stock turning into the next Microsoft (MSFT) are more miniscule than the aforementioned double lottery pick.

At the pmcw Report we won't scream about what you "must own", "must sell" or anything you must do today. We'll try to give you a candid and objective opinion of what we see in the market and present you with some investment ideas we feel have merit. Rather than trading "candy" that will rot your wealth, we'll try to present a balanced diet of fundamental common sense we hope you will be able to use as one of several ingredients in your recipe for successful investing.

Anyone serious about leaning how to invest should read "The Warren Buffett Way" by Robert G. Hagstrom. After you read it the first time, read it again and then keep it on your shelf as a textbook.

When I read the Buffett Way the first time no one told me what to look for before I started. It was up to me to figure out what lessons were important and how to apply these lessons. Like Buffett, I'm a big fan of keeping things very simple so let me offer you my opinion of what I feel are the most important lessons.

1) Stick with what you know best. This is not to suggest you shouldn't learn to become more proficient and expand your capabilities. However, it is important to understand your capabilities and what is necessary if you really want to become a serious investor. If you do less and just "play" at the game you'll end up losing to those who are more dedicated and able. Sure, there are those who will buy a lottery ticket and win, but there are millions who will buy them everyday and lose. The first lesson is to not play games where winning matters if you don't have a better than fair chance of winning.

2) Understand how to value a business. This goes beyond learning how to evaluate the fundamentals of Price to Earnings (P:E) ratios and the simplified metrics presented in the daily paper. It involves modeling long-term discounted cash flow, learning enough about how a company is capitalized to judge if they have the necessary resources to succeed, being able to assess the quality of a management team, leaning the markets the company serves, gain an understanding of the company's potential within these markets and being able to judge the long-term viability of the company's ability to differentiate itself in a competitive environment.

3) Understand your own limitations and don't stretch beyond their reach. Essentially, this means to focus your time and resources in learning everything you can about the companies in which you will invest. This will lead you to the conclusion, if you're lucky, the best way to optimize your return is to hold just a hand full of stocks and only invest when you know enough to put a substantial amount on the line.

Behind Buffett’s Success:

The team of Buffett and Co-chairman Charley Munger is the product of their two mentors: Benjamin Graham and Philip Fisher. Graham was the high priest of quantitative valuation and focused all of his energies studying all the financial materials and reports available on the companies and industries that he chose to explore. To a certain extent, one could say Graham simply compared value and price based on the numbers. Fisher, on the other hand, concentrated on management and potential. He looked beyond the numbers of today to what was likely to happen tomorrow. He was also very keen on focusing his efforts and money with only a few companies.

Fisher was influenced heavily by what he liked to term "scuttlebutt." He would use what we call "field contacts" to learn about how a company's management and products were being received in the field. He was a people person and Graham was a numbers person. Graham looked for a company selling for less than the current value that had a good chance of staying the course and Fisher looked for companies that were in an evolutionary process leading towards expanding markets and profits. To a great degree, Graham and Fisher lived and operated in parallel worlds and it took outsiders that appreciated the strengths of the two approaches to bring them together. The resulting combination of these different disciplines just so happens to be one of the largest fortunes created in the history of the world and, by far, the larges fortune ever created through investing.

Learning to Walk the Walk:

Believe me, the lesson to focus ones energies and investments didn't come easy to me. To a certain extent, this philosophy conflicted with so much of what I was taught that accepting it was counterintuitive. To focus so much of ones worth in only a few investments appeared to add unacceptable risk and defy the seemingly sound logic of diversification. However, years after reading the Buffett Way the first time I learned that a focus strategy, done right, can significantly reduce risks.

From my early investing experiences in the mid 60's and early 70's, I didn't need to learn not to trade stocks like a jackrabbit does mates. I held my first investment in ComSat for years until I sold it for ten times the purchase price and rolled the proceeds into Pizza Hut. The latter performed similarly to the former and funded both my first business, what college I took time to attend and was the cushion that allowed me to start the company that eventually provided me with the option of "early retirement."

Hyper-trading is a fool's folly. Sit with any "successful" trader and they will fill you with stories about how they doubled and tripled their money time and time again. However, they will fail to mention how many times they lost, how many times they should have just held, how much of their profits they paid in taxes and they will never be able to explain why, after all these doubles, they are not as wealthy as Buffett and Munger. I'll tell you why. Even when they pick a winner they've not done enough research to where they can rationally invest a substantial portion of their wealth. Due to this lack of research (their lazy approach) they invest only a minute portion of their net worth, lose more frequently than they will admit and sell what could have been big winners after a short run up.

The reality is the "successful" traders are better at selling their services than they are at making money. The traders with big corner offices and names you might recognize make their real money from the commissions they charge others to deliver sub-Buffett performance. I'll say it one more time, they are better at convincing others to pay for their sub-par services than they are at delivering real profits. Personally, I'm much more interested in optimizing my profits and minimizing my risks than I am in generating trades, commissions and gains taxable at the rate of regular income. I'll let the traders fund the lifestyles of James Cramer and Richard Grasso, neither of them bring value to my party.

Even though I've never fallen prey to the folly of hyper-trading I did fall deeply into the clutches of false-diversification. I'm not talking about "good diversification"; there is a radical difference with what some feel is diversification and real risk minimizing diversification. My diversification was like most investors - an illusion of security.

Like most investors I know, when I found a new stock I liked, I ran the numbers (actually, a step beyond what most take) and I bought a modest position. Fortunately, for the most part, I did well and most always beat the broad market, but I seldom optimized profits and finally learned that I exposed myself to significantly higher risks than what I intended. Think about that, my efforts were not only wasted, they were counterproductive! Through improper diversification I increased risks and lessened my potential to profit.

What I learned is there is no possible way for an individual investor or even a manager with a team of advisors to properly accumulate and balance all the information necessary to make the right decisions as to what to buy, what to hold and what to sell in a portfolio of stocks that at one time approached the "diversification" of a small mutual fund.

The way to make serious money in the profession of investing is to take the necessary steps (this is involves a ton of work) to find companies with the potential to be huge winners, to continue putting in the hours to insure these companies are on track and to hold them until something changes. There is absolutely no way to shortcut this process of sound investing.

At best, most investors only do a small part of this job. They might luck into finding a good company like a Dell (DELL), Cisco (CSCO) or Linear Technology (LLTC) before they are recognized by the crowd as winners, but they will only invest a modest percentage of their worth and seldom hold long enough to reap the big rewards. They only invest modestly because they've not taken the time to really understand the company, the market and the management and they will not know whether it is right to hold or take profits because they don't stay on top these critical issues.

If you contrast the pmcw Report with the vast majority of the newsletters published today the most striking difference is virtually all the others seem to think they can pick a winner per day. At best they are lying to themselves and at worst they are lying to their members. It can't be done - not by Warren Buffett, not by Charley Munger, not even by the legendary Peter Lynch - not by no one, no how, no way. This is one bit of knowledge I can confidently say I share with Buffett, Munger and Lynch. And, I'll share it with you because I don't need to make a living from feeding unknowing members with trading candy trades and poorly diversified portfolios just to show activity. As Mark Twain said, "Don't confuse movement with progress."

Really Good Decisions:

The first really good decision is to read “The Warren Buffett Way” and understand how the truths therein apply to you. The next five are how you execute. You see; all you need to do is follow the basic principles, if you feel they are well suited for your persona, and execute on five good investments. If you are able to find and capture five really good investments over a lifetime I can almost assure you a comfortable retirement. You may not make billions like Buffett and Munger or hundreds of millions like Lynch, but you’ll most certainly be better off than you would if you tried to trade your way to fame and fortune. Not only that, you’ll find investing to be a much more comfortable endeavor than you thought possible.

Far too few people read the appendix of the books they purchase. The appendix of "The Buffett Way" contains a wealth of information. The first part of the appendix is a very short case study listing the investments in public companies held by Buffett and Munger from 1977 through 1993. It shows their portfolio of focus stocks starting value at roughly $101M and ends up with $11.3B. I hope the first thing you notice is that their entire portfolio fits very neatly onto a single page and is often comprised of only five stocks. If you run through the investing history you'll also notice the vast majority of their fortune can be attributed to only five really good decisions.

Focus and Diversification Meet:

Far be it from me to suggest the average retail investor should try to follow a focus approach with 100% of their net worth. Leave this approach to those who know how and have both the capability and resources. However, I strongly suggest retail investors who want to own individual stocks start by first dividing the money they wish to invest in equities into two piles. One pile should be dedicated to the ultimate form of diversification - Index funds. I've written a few times about the value of index investing. One is the Primer called "The Zero Sum Game" and the other is a dashboard entry you can find by looking in the archive for the report published September 16, 2003 titled "The Cost of Money Management." If you’re only going to read one, chose the latter, but I recommend both.

In the world of index funds I prefer the Vanguard Total Market fund that emulates the Wilshire 5000 Index (this is the index that includes all stocks traded on all three major US exchanges). However, there are a wide variety of index funds available that you might feel are better suited to support your goals. They range from international funds, to small cap funds, to the most common, the S&P500 index funds. How much you dedicate to index funds is a product of your personal goals, but for most, it should be the majority of their equity allocation.

Your index allocation is the ultimate couch potato investment you can make. Once you have it in place all you have to do is rebalance it about once every year. Beyond that, it's autopilot and, if you choose, the couch and a beer. Forget about investing and let the index do the rest.

If, after thinking it through, you decided you would like to invest a portion of your equity allocation in individual stocks, the pmcw Report might help you find some nice options. We'll certainly discuss the macro-economic events you need to know for making wise allocation decisions with your broad portfolio, but our real focus is to find the potential big winners, follow them closely to insure they stay on track and keeping you appraised about what’s happening in the world of high technology. If you’re new to our site, please see our suggestions below the “bottom line” to help you better understand the resources available.

Bottom Line: When you stop and think it through, it makes perfect sense that the odds of finding five really good investments in a lifetime should be considerably easier than making hundreds of successful trades. The problem is most people don’t think that far ahead and, even if they do, they must think their odds of being extremely lucky are better than their odds of them making sound decisions. Go figure, we go to great lengths to teach kids the virtues of the tortoise winning the race by keeping a determined and steady pace, yet when they grow up and it matter most, they act like jackrabbits with attention deficit disorder.

Sign up for your 21-day Risk-FREE trial and receive complete access to Next Inning