1. Look for market anomalies or “disconnects.”
Many of the best investors hunt for special situation stocks where the market is either ignoring some important development or is overreacting to some news. Sacramento engineer Mike Koza pounced on a select group of financial stocks during the financial meltdown on the theory that the market was overreacting, punishing all financial stocks too severely. In the summer of 2008 he bought the stock of Radian Group (RDN), a mortgage insurance company that had dropped to as low as a dollar.
He pored through RDN’s financials, listened to management conference calls and determined that the stock was worth at least $20. He eventually sold the stock at $12 earning more that a 1,000% return. Koza calls these instances where a stock’s price appeared to be completely out of whack, “disconnects.”
Advice: Keep an eye on the day’s top gainers and losers. Stocks often swing wildly when the market over-reacts to a piece of news. It is a can be a good starting point for ideas that need more investigating.
2) Don’t obsess about diversification.
Many financial advisors will harp on you about keeping your portfolios widely diversified. It falls under the “don’t put all your eggs in one basket,” adage and it’s touted as a great way to minimize risk. What most advisors don’t stress is that being widely diversified can also kill your chances at having outsized returns. And remember, even “widely” diversified portfolios were flattened during the financial meltdown of 2008.
I found that the 10 Warren Buffetts Next Door often allocated disproportionate amounts of capital to stocks they were convinced were deeply undervalued–where their chances of high returns far outweighed the downside risk they estimated. Their portfolios ranged in size from 10 to 40 stocks. However at certain times, they would make big bets on a few equities. In the case of Alan Hill, a retired education executive from New Mexico, his big investment in a single stock, Bancolombia, SA (CIB), allowed him to make enough money to build a dream retirement home.
Alan Hill and the amateurs profiled in my book are not alone in this strategy. Virtually all of the great fund managers do this, Soros, Buffett, John Paulson… In fact The Oracle of Omaha once said that “ Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
Advice: Check your investment and retirement portfolios to see that they aren’t “over” diversified in that they own hundreds or thousands of stocks or conversely that you don’t have multiple funds in different accounts investing in the same thing. If you manage your own portfolio and can afford it, don’t be afraid to invest outsized amounts in stocks you are highly confident are undervalued.
When most people buy stocks they use two currencies, the kind that you get at a bank, money, and emotional currency, which often involves a bit of ego. It goes like this: because of the great research you have done, you become convinced you are right on a stock, even if the market goes against. ‘The market is wrong, other investors are stupid.’ This is very dangerous. Don’t fall in love with your stock picks. You need to set up sell rules, say a 25% decline in price.
Advice: Periodically go through your portfolio holdings to determine if the stocks in it are still a good value according to your original investment criteria. Be clinical about it. If they no longer measure up, sell them or at least sell a portion of the holding.
4) Don’t be lulled by dividend payments–beware of value traps.
Sometimes stocks appear to be bargains on the surface because they either have high dividend yields and low P/E’s or are sitting on a pile of cash. Sometimes these stocks are indeed great buys, but sometimes they are value traps. These are stocks that may never appreciate in price, are cheap for good reason or there is some overriding macro trend that will ruin the rosy future you are envisioning. Washington Mutual Savings, better known as WAMU, to scores of investors looked like a screaming buy with a high dividend in 2007. Many investors piled in and lost a lot of money after the mortgage crisis put an end to WAMU and its high dividend yield.
Advice: Like a pit manager on a NASCAR team, you should run you stocks through a maintenance check each month. Re-evaluate the reasons you are holding the position to make sure they are still valid. Check relevant news and read the fine print of financial statement. For dividend stocks, consider the viability of the company’s earnings stream in maintaining the dividend. Above all, don’t ignore big macro trends that could impact your forecast.
5) Work to minimize your mistakes.
The same rule holds true for club level tennis players. The one who makes the least mistakes usually prevails. Investors in my book regularly review their portfolios to see that they are not taking undue risks in any one position. One WBND, Chris Rees, was so obsessed with protecting his downside that he told me his main investment strategy was “don’t lose money.” Of course he didn’t have a perfect track record on that score, but he did often run through worst-case scenarios on his stocks and would only consider buying a new stock if he thought it could be had for half his calculation of it’s intrinsic value.
There are also dumb mistakes investors need to avoid, like holding onto losing stocks too long (would the money be more productive in another stock?). Another dumb mistake for mutual fund investors is to ignore expenses. Expenses and other fees can make a big difference in your long-term returns. Make sure your fund’s expenses are relatively low in its peer group.
Advice: Same as above, when running your regular portfolio review, go through some “what if” worst case scenarios on each of your holdings. One WBND in my book, Randy McDuff of Winnipeg, Manitoba, would write out his thesis on each stock, as though he were a professional stock analyst, in an effort to crystallize his reasoning and run a check. Another important but overlooked point is to keep good records of your accounts, transactions and research. This can minimize mistakes and help you come tax time.
There is no shame in copying the moves of better investors or industry insiders you respect and revere. All of the best investors do this. Just check out who the other owners are on stocks in Berkshire Hathaway’s (BRK) portfolio. It’s a laundry list of top flight hedge funds. I recently wrote about how a number of top hedge funds, including David Tepper’s Appaloosa Management, bought into fertilizer company Mosaic (MOS) along with Goldman Sachs and a number of other top hedge funds.
Billionaire Tepper would be a good investor to ride the coattails of. In my book several investors sought out smarter investors on Web message boards like ValueForum.com. Gold investor Andrew Swann once made a killing riding the coattails of a smart industry executive who he noticed had landed at a new firm. Other investors track insider buys and sells, or regularly review 13F filings of stock holdings at www.sec.gov.
Advice: Keep an eye on changes in 13F filings at the SEC. This will give you a leg up on where the smart money is moving. Several Web sites including www.marketfolly.com and www.gurufocus.com, regularly update readers on hedge fund moves. Another premium site, www.insiderscores.com tracks insider buying and selling.
7) Pay attention to taxes.
It’s not just about how much money you can make on an investment. It’s also about how much you get to keep. Taxes can have a big affect on your returns. One of my Warren Buffetts Next Door, Alan T. Hill, converted his entire portfolio from traditional IRA to separate Roth IRAs sector by sector, giving him the opportunity to reverse the move if any one sector portfolio plummeted. Other investors I have talked to only buy stocks or preferreds with dividends eligible for the favorable 15% tax rate on qualified dividend income.
Advice: Consult a tax expert and read the coverage by my colleagues Janet Novack (click to read her stories) and Deborah Jacobs (click to read her stories). Both write about smart tax strategies for investors.
Successful investing takes time and passion.
Being a good investor doesn’t just happen, it takes a lot of time and effort. Every single investor in my book spends at least 3 hours per day working on his portfolio, or at least thinking about investment ideas. Some, with 9-5 day jobs, spend more than 5 hours a day. The second part of the equation is passion. You won’t devote a lot of time to investing and learning to be a better investor, if investing has no allure for you. You have to love the process and it should be fun for you. All of the Warren Buffetts Next Door are passionate about investing.