Playing 'Follow the Guru' Can Be Fun - and Profitable - for Investors

[Editor's Note: The second of two parts. Part I appeared yesterday (Wednesday). To read that story, please click here.]

If you wanted to distill all the world's best investment advice into a single sentence, it would probably come down to this: Follow the leader.

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.

We've whittled the investing wisdom of these three stalwarts - and others - into 15 rules to live by. We offered the first five rules in Part I of this story, which appeared yesterday (Wednesday). Here in today's second installment, we offer the final 10 rules.

6. Focus on Fundamentals: The "fundamentals" can vary from one company to another, or one industry to another - depending on the type of company you're looking at. Lynch contends that fundamental "value" has to be determined differently for different types of companies. He divides companies into three categories:

  • Fast-growers, which have earnings-growth rates of at least 20% per year.
  • Stalwarts, which have multi-billion-dollar sales and earnings growth of 10% to 20% per year.
  • Slow-growers, which have single-digit earnings growth and high dividend payouts. This category generally includes financial stocks, though Lynch has special criteria that he applies to stocks in this sector.

With respect to fundamentals and value, Buffett, Lynch and Templeton all include one overriding principle:

Never buy a stock unless you can explain exactly why you're buying.

Buffett's Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B) never buys "businesses whose futures we can't evaluate, no matter how exciting their products may be," Buffett explains. "Most investors who bet on the auto industry in 1910, planes in 1930 or TV makers in 1950 ended up losing their shirts, even though the products really did change the world. 'Dramatic growth' doesn't always lead to high profit margins and returns on capital."

7. Be a Contrarian: Value is important - and the best time to find it is when no one else can see it, or is too afraid to buy it. Both Buffett and Templeton said it concisely: "Buy when everyone else is selling."

Buffett specifically noted in his 2010 report to shareholders that Berkshire has "put a lot of money to work during the chaos of the last two years. It's been an ideal period for investors: A climate of fear is their best friend."

Indeed, one comment is well on its way toward becoming a classic investing adage: "Big opportunities come infrequently," Buffett says. "When it's raining gold, reach for a bucket, not a thimble."

The obvious corollary to this is, "Don't buy when everyone else is buying."

Lynch stresses this point, saying you should never rush to buy a stock for fear of missing a $2 or $3 rally. "You always have plenty of time to ... identify exceptional companies."

8. Good Management Creates Good Companies: This is high on almost everyone's list. Lynch says management is often the difference between a good business and a marginal one, and Buffett views the managements of the companies he buys as his "partners" in business.

Lynch says he prefers "a conservative management style" that can balance risk with safety because "companies don't succeed over the long term unless they take risks." Things can still go wrong at companies like these, he notes, "but conservative management avoids the 'bet-the-company' gambles."

Buffett does, however, offer one warning on this subject: "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is usually the reputation of the business that remains intact."

9. Invest for the Long Run: With the possible exception of Soros, who manages a hedge fund with a focus on commodities, this rule is also high on everyone's list.

"Absent a lot of surprises, stocks are relatively predictable over 10-20 years," Lynch says. "As to whether they're going to be higher or lower in two or three years, you might as well flip a coin to decide."

In order to explore his belief that "trying to predict the short-term fluctuations of the market just isn't worth the effort," Lynch conducted his own study of market timing during the period from 1965 to 1995. In that study, Lynch discovered that an investor who bought at the lowest point each year would have enjoyed an advantage in return of just 1.1% over one who bought at the absolute highest point each year.

"Forget short-term market timing," he advises, "and focus on the most important task - finding great companies. If the company is strong, it will earn more and the stock will appreciate in value."

Buffett agrees, noting that this philosophy is the reason the turnover in Berkshire assets is just 10% to 15% per year, compared to an average portfolio turnover among growth mutual funds of almost 100% per year. Templeton was also famed for having one of the lowest annual turnover rates in the mutual fund industry, maintaining many positions for several decades - with results to prove the wisdom of that strategy.

In fact, according to Morningstar Inc., the Templeton Growth Fund (TEPLX) still has a turnover rate of just over 10% a year.

10. Make Time Your Ally: Never underestimate the power of compounding. As an extension of Rule No. 9 (Focus on the Long Run), the proof of this rule lies in the performance numbers cited in Part I of this article. The difference between the 13.4% return of the Templeton Growth Fund and the 9.3% return of the Standard & Poor's 500 Index isn't that much in a single year - but from October 1964 to the present, $10,000 invested with Templeton would have grown to roughly $3 million - compared to only $560,000 for the S&P 500's $560,000.

11. Delve for Dividends: Many active investors scoff at dividend-rich stocks, claiming they're dull and lack any real growth potential. Lynch, Buffett and Keith Fitz-Gerald, Money Morning's own chief investment strategist, all dismiss this as a fool's opinion.

Fitz-Gerald recommends keeping at least 50% of your portfolio in secure, dividend-paying stocks - both to maintain a safety net in turbulent times and to provide a steady stream of income to finance new opportunities and an occasional high-return speculation.

Buffett agrees, noting that - in addition to its primary portfolio - Berkshire holds roughly $26 billion in non-trading securities of companies like The Dow Chemical Co. (NYSE: DOW) and General Electric Co. (NYSE: GE) because "these holdings deliver us an aggregate of $2.1 billion annually in dividends and interest."

In addition, a variety of studies have shown that dividends have accounted for a substantial portion of stock returns - perhaps as much as 95% depending on the period covered - over the past century.

12. Stay Liquid: Dividends are also valuable in reducing the need to borrow money. This applies to both individuals and the companies in which they invest, as explained by Buffett:

"We will never become dependent on the kindness of strangers," Buffett said. "We will always arrange our affairs so any requirements for cash we may conceivably have will be dwarfed by our own liquidity. Moreover, that liquidity will be constantly refreshed by a gusher of earnings from our ... diverse businesses."

13. A Good Defense Will Beat a Good Offense: This is another of Buffett's prime tenets, echoed by everyone from Money Morning 's Fitz-Gerald to Carlos Slim Hel ú, the Mexican telecom industry giant who this year replaced Buffett as the world's richest man.

Buffett says the reason for Berkshire's huge return advantage is that "we have consistently done better than the S&P in the 11 years during which [the index] delivered negative results. In other words, our defense has been better than our offense."

Fitz-Gerald also advises his followers that concentrating your investments to avoid major losses is far more important over time than focusing on capturing major profits, simply because it takes a far bigger price move to recover lost assets than it does to make profits in the first place.

Slim puts it in even simpler terms: "Everyone makes mistakes, but try to make mostly small mistakes ... In business and in personal life, try not to make big mistakes."

14. Set Reasonable Goals: This is a nother rule on which all the experts agree. If you're looking for a major score every time you buy a stock, you are speculating - not investing.

"Avoid long shots," Lynch says in one of his shortest strategy points.

Buffett concurs: " I don't look to jump over 7-foot bars; I look around for 1-foot bars I can step over."

By the same token, Lynch cautions against selling stocks just because they've meet initial goals or holding others because they haven't. He also warns against buying more of a losing position.

"I've always felt this amounted to pulling the flowers and watering the weeds," he quips.

15. Watch What You Own - And Be Flexible: Jim Rogers, former manager of the Quantum Fund, creator and manager of the Rogers International Commodity Index (RICI) and author of "A Bull in China: Investing Profitably in the World's Greatest Market," is famed for saying: "Markets often rise higher than you think is possible, and fall lower than you can possibly imagine."

Given the accuracy of that statement, both Carlos Slim and George Soros emphasize being flexible.

"I don't have a particular style of investing - or, more exactly, I try to change my style to fit the conditions," Soros says, basing his actions on what he calls his "theory of reflexivity." "I do not play according to a given set of rules; I look for changes in the rules."

Lynch and Buffett phrase it a bit more precisely, saying never be afraid to get out of a position if circumstances within the company change.

"Should you find yourself in a chronically leaking boat," Buffett says, "energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks."

As for advice regarding when to sell, we'll only cite one rule here - provided in one form or another by nearly every one of the experts:

Sell when the reason you purchased the stock in the first place no longer applies.

[Editor's Note: For a related story - on Warren Buffett's checklist for success - which appeared in yesterday's issue of Money Morning, please click here. Part I of this story appeared yesterday (Wednesday).]

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