Rule Maker stocks can provide a great start to an individual stock portfolio. But if a stock isn't a Rule Maker, that doesn't mean it can't be a good investment. There are plenty of other investing techniques that can be profitable.
First, though, a word of warning: Some of these strategies are not for the meek. For instance, Rule Breakers are for the most bold and daring of investors. Those who are brand new to all of this investing stuff should understand the risks involved. So should those who aren't new to the field.
Rule Breakers
The primary Rule Breaker philosophy is that high risk can bring high rewards. Because of that risk, though, Rule Breaker stocks should make up only a part of any portfolio -- and investors should be prepared to lose the money they invest in these companies.
Here are the six main characteristics of Rule Breaker companies:
1. The company should be a top dog and a first mover in an important, emerging field, as Amazon.com (Nasdaq: AMZN) was with the emergence of electronic commerce. Being top dog in the left-handed-scissors industry isn't enough.
2. The company needs to demonstrate that it has gained a sustainable advantage, through business momentum, patent protection, visionary leadership, or inept competitors. Examples include Wal-Mart (NYSE: WMT), with net income gains of 25% during much of the 1980s; Amgen (Nasdaq: AMGN), with patent protection of its drug formulas; and Microsoft (Nasdaq: MSFT), with visionary leadership that benefited from Apple's (Nasdaq: AAPL) regrettable decision not to license its technology.
3. The market should have rewarded a Rule Breaker's promise with strong price appreciation, measured by a relative strength rating of 90 or above. (Relative strength ratings appear in Investor's Business Daily.)
4. Look for good management and strong backing. The steel company Nucor (NYSE: NUE), led by Ken Iverson, became a world-class powerhouse by revolutionizing steel production processes. Also consider the "backing," or the supporters of a company.
5. Rule Breakers should have a strong consumer brand. Consider eBay (Nasdaq: EBAY). Its name recognition is much stronger than competitors such as ... um ... like ... (get the point?).
6. It's a good sign when the financial media call an up-and-coming company "overvalued."
Again, we recommend making Rule Breakers just a part of your overall investment strategy.
The beauty of small-cap investing
You should also consider including a number of small-cap growth companies in your portfolio, Rule Breakers or otherwise. Small-caps give the individual investor a chance to beat the Wise to the punch.
The size and structure of most mutual funds and a pesky SEC regulation make it hard for funds to establish meaningful positions in small caps. To buy a position large enough to make a difference to their fund's performance, they would have to buy 10% or 20% of a small-cap company, and their own guidelines frequently restrict them from doing so.
Before they can do that, though, they have to file with the SEC. By that time, they've already tipped their hand to the market and inflated the previously attractive price by buying 5% of the company. Individual investors who have the ability to spot promising companies can get in before the institutions do. When institutions do get in, they'll do so in a big way, by buying many shares and pushing up the share price.
Another reason to buy small-cap companies is that they can grow quickly. Small companies are in a much better position than their larger brethren to expand their businesses. Rapidly multiplying earnings often translate into higher share prices.
The downside of small caps
Small caps are for experienced investors. Novices should steer clear. You wouldn't go up in a lunar orbiter without previous training, nor should you try small-cap investing until you've cut your teeth on some large- and mid-cap issues.
Time -- or the lack thereof -- is another dissuading factor. Finding good small-caps is a lot of work before and after you've made your purchase. If you don't have the time, energy, or inclination to keep up with the news on your portfolio, you're better off in an index fund. We're serious about this. We'd even rather you just pay fees to some expensive mutual fund out there than go into small-cap investing with a lackadaisical attitude. (Wow, did we just say that? Whew! Down, boy.)
Finally, if you have a natural aversion to risk, stay away from volatile small-cap growth stocks. If the mere thought of a 5% drop in one day gives you an ulcer, you're better off saving your stomach. Index funds will give you respectable returns without the acid-blockers.
Going global
For a long time, many investors didn't think much about international investing. After all, the United States is the most diverse economy on the planet, the driver of global growth, and the country with -- by and large -- the best shareholder protection framework. What's more, you could (and can) get a ton of international exposure by holding U.S.-based companies with international reach, such as McDonald's or General Electric.
The Wise have long said that foreign investing is risky. However, as the economy has grown more global, it just doesn't make sense anymore to say that investing in a foreign company is inherently riskier than investing in a U.S. company. As a group, international stocks are no riskier than U.S. stocks are. Foreign companies offer substantial diversity in the same exact way that U.S. companies do, ranging from Rule Maker-type stocks to speculative small-caps with high growth potential.
Yes, it is risky -- but probably less than you think
All investing has an element of risk to it. But during many periods in the past, the U.S. market has underperformed many international markets. Often, when stocks are expensive at home, you can find intriguing bargains around the globe.
Finding great international businesses offered at prices that underestimate potential gains can be a successful strategy. Although the resources to do research on international businesses aren't necessarily as readily available as those for U.S. companies, the added difficulty often leaves undiscovered opportunities to find attractive investments.
Value investing
Wall Street frequently divides investors into two camps -- value and growth. This somewhat arbitrary distinction is meant to separate businesses with high growth rates, which often trade at relatively high valuations, from more mature businesses that are cheaper relative to the overall stock market.
Yet despite this division, a broader approach to value investing involves looking for companies whose stock prices are lower than the actual intrinsic value of their businesses. The difference provides a margin of safety for investors, in that even if you make a mistake estimating intrinsic value, a lower stock price gives you an extra cushion from losses. You can look for such bargains not just in mature industries but also among companies whose shares most would call growth stocks.
There are several different flavors of value investing. Some follow the route of legendary investor Benjamin Graham in looking for statistically cheap stocks that trade at or below book value (shareholder equity from investments in the company plus retained earnings), preferably with a substantial margin of safety of at 50% to intrinsic value. These are the "deep value" guys, and when a stock approaches intrinsic value, they sell and repeat the process.
Others are more like Warren Buffett and Charlie Munger at Berkshire Hathaway, still looking for a big margin of safety but with the caveat that they're prepared to pay up for companies that display long-term competitive advantages. These don't necessarily outperform the market in the short term, but over the long haul, their competitive strengths allow investors to compound market-beating returns without losing sleep. Companies like these typically have extraordinarily high returns on invested capital and management that returns excess cash to shareholders through increasing dividends and share buybacks.
Finally, some value investors follow the path less traveled and are true contrarians. They look for value in distressed companies that few others want.
The common theme is that value investors look for stocks that are more valuable than their stock price suggests. Over time, that can be a recipe for substantial gains.
Dividends and investing
Another method investors use to pick stocks is to focus on the dividends they pay. There are a number of reasons why focusing on dividends can be helpful.
1. Bear-market protection. When the stock market is falling, dividend-paying stocks often tend not to fall as far as non-dividend-paying stocks do. In addition, as long as companies keep paying dividends, you're getting paid to hold your shares through good times and bad. Over the long haul, those regular dividend payments can make all the difference.
2. Less volatility. Companies with serious commitments to their dividends can be unbelievably boring. That's a good thing. The healthy yields that companies pay in dividends can help put the brakes on a stock-price slide. That may seem like a small consolation, but when volatility and bear markets strike, dividend payers can help you sleep better at night.
3. Better transparency. While experienced analysts can disagree on the valuation of any given company, you can't argue about a dividend check. It's concrete, it's tangible, and you know exactly how much it's worth. In contrast, with complicated accounting systems that are subject to interpretation, fudging the financials is something you have to worry about. It's far more difficult to fudge the numbers when you have to dole out cash to shareholders.
4. Historically, dividends matter. According to one study, from 1926 to 2004, 41% of the return in the S&P 500 came from dividends. That seems hard to believe today, now that the yield on the S&P 500 is less than 2%, but it's true. With the effects of reinvesting and compounding accounted for, the returns are simply staggering.
5. Market-beating results. According to Wharton professor Jeremy Siegel and his thoroughly researched book The Future for Investors, the original S&P 500 has outperformed the regularly updated index. More importantly, dividend payers tend to beat the market over long stretches. Why? According to Siegel, they outperform the market because of the benefits of reinvesting dividends during declines.
Those are just some of the reasons dividend investing makes sense -- and why it can help you beat the market.
A lot to chew on
We understand that this is a bit much to grasp all at once. But we feel that it's important to give you at least a glimpse at the various methods that experienced investors use to make money from stocks.
Now that you have various investing strategies under your belt, proceed to Step 12, where we'll look at some even more advanced investing issues.
To see the rest of the 13 Steps, follow the links at the bottom of this article.
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