Playing 'Follow the Guru' Can Be Fun – and Profitable

[Editor's Note: The first of two parts. Part II will appear tomorrow (Thursday).]

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If you wanted to distill all the world's best investment advice down into a single sentence, the result would actually be fairly simple:

In short: Follow the guru. That's not just a clever phrase. In fact, if you picked any of the investment world's living legends and copied what they did, odds are you'd be pretty successful over time, regardless of the general market environment during any given short-term period.

After all, who could possibly complain if they managed to equal the astounding-but-consistent results produced by Buffett's Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B): A $10,000 investment made in October 1964 would be worth roughly $82 million today, an annualized return topping 22%, with an average yearly increase in book value of 20.3%. Not bad for a stock that's trading at a whopping $122,000 a share.

No one else in the investment realm has come even close to those numbers, though two others did do quite well. During the same 45-year period, fund tracker Morningstar Inc. says the Fidelity Magellan Fund ( FMAGX), formerly managed by Lynch, ranked the highest, returning an average of 16.3% per year.

And the Templeton Growth Fund (TEPLX) , managed for much of that period by the late Sir John Templeton, came in second, growing by 13.4% a year.

By contrast, the Standard & Poor's 500 Index generated an average annual return of 9.3% during this same period, meaning $10,000 invested in late 1964 would have grown to nearly $560,000 by year-end 2009.

Of course, recognizing the returns achieved by the world's greatest gurus and actually duplicating them with your own stock investments are two entirely different things. But, thankfully, those investment icons have been remarkably generous with their advice, freely sharing their overall investment philosophies as well as specific investment strategies.

Money Morning has distilled all that into 15 essential guidelines for achieving your own market success.

Following them may not land you on next year's list of the world's richest people, but over the long run, these tips will certainly give you a leg up on the average investor running with the Wall Street crowd. The order of presentation doesn't reflect the individual importance, though several come from more than one advisor – including the first:

1. Only Buy What You Know: This bit of wisdom tops Peter Lynch's set of rules and is found, in one form or another, on nearly everyone else's list. Lynch boasts that he discovered many of his best investment ideas while strolling through the supermarket, the hardware store or while talking with family members or friends.

"We all have the ability to do first-hand analysis when we are watching TV, reading the newspaper or listening to the radio," Lynch explains, noting that you should always be looking for new investment ideas, whether you're just driving down the street, shopping near home or away on vacation.

"After all," he says, "consumers represent two-thirds of the gross domestic product (GDP) of the United States. That means most of the stock market is in the business of serving you, the individual consumer – so if something attracts you as a consumer, it should also pique your interest as an investor."

One caveat: If you're attracted to a stock because of a specific product or service, be sure it represents a large enough percentage of the company's sales to be meaningful. No matter how good a product is, if it only accounts for 5% of sales, it will likely have only a marginal effect on profits.

2. Buy the Best Brands: Look for companies that have built up the value of a brand name. Buffett also believes in buying only what you understand – but he says a single good product or idea isn't enough.

"Investors who buy and sell based upon media or analyst commentary are not for us," Buffett wrote in this year's Berkshire Hathaway annual shareholders report. "We want partners who join us at Berkshire because they wish to make a long-term investment in a business they themselves understand, and because it's one that follows policies with which they concur."

However, Buffett adds that those companies also need to have a brand identity strong enough to "ensure their continued dominance in the market" in which they operate. Brand dominance is also a preface to another of Buffett's key rules:

3. Don't Ignore the Bottom Line: When it comes to investing, the bottom line is truly the bottom line. Don't invest in a company that lacks sustainable earnings power. Buffett says companies can only earn high profits when they have an ongoing competitive edge over other firms in the same business.

"Wal-Mart [Stores Inc. (NYSE: WMT)] has incredibly low prices. Honda [Motor Co. Ltd. (NYSE ADR: HMC)] has high-quality vehicles," he explains. "As long as (they) can deliver on these things better than anyone else, they can maintain high profit margins. If not, the high profits attract many competitors [who] will slowly eat away at the business and take all the profits."

Buffett says any truly great business "must have an enduring 'moat' that protects excellent returns on invested capital." He also says such companies are often worth buying even if they're not undervalued, having noted in the past that "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

4. Buy the Business, Not the Stock: A lot of people make their "Buy" decisions based on what a company's stock happens to be doing at a given moment, but the most successful investors focus on what the business is actually doing. Successful investors eschew market timing, preferring to enter when the fundamentals are strongest or when the value relative to price is greatest.

"If a business does well," Buffett contends, "the stock eventually follows."

5. Always Do Your Homework: As an extension of Rules No. 1 and 4, Lynch says that shrewd research is essential to finding real value. While firsthand observations and anecdotal evidence are a great start, he credits his success to rigorous research.

Lynch's favorite fundamental indicator is one he actually invented – the so-called Price/Earnings to Growth Ratio, more commonly known as the "PEG Ratio." The PEG divides a stock's current Price/Earnings (P/E) ratio by its historic growth rate to find undervalued growth stocks, with a lower PEG reading indicating a more undervalued stock. Lynch says the PEG adjusts a high P/E ratio to reflect a faster rate of growth for the company.

Along with the PEG, Lynch also analyzes fundamental variables like the debt/equity ratio, earnings-per-share (EPS) growth rate, inventory/sales ratio and free cash flow (FCF). He says that companies with strong cash positions and low levels of debt have much more flexibility to seize opportunities for growth.

Buffett analyzes a wide range of fundamental factors – too many for us to single any out – but all the gurus are focused on finding value in a company. Buffett's definition of value includes strong cash positions, low debt, good management and the potential for strong future sales – not just over one or two years, but over a decade or two. He also warns against confusing revenue growth with business success.

"Sometimes businesses look good in terms of revenue growth," he explains, "but require large capital investments all along the way to enable this growth. This is the case with airlines, which generally require new aircraft to significantly expand revenues … [leaving them] heavily laden with debt. This can leave little left for shareholders and makes the company highly vulnerable to bankruptcy if business declines."

[Editor's Note: For a related story - on Warren Buffett's checklist for success - which appears elsewhere in today's issue of Money Morning, please click here. Part II of this story will appear tomorrow (Thursday).]

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  1. Charles Kaluwasha | April 2, 2010

    Investing in a sustainable business is profitable and you will have confidence in a business that has been built on firm foundation by the gurus who have seen the down side and the upswing of a brand.
    This is a very high profile article that high lights the fundamental concept of a profitable business online.

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