The 5 Secrets to Buying Stocks

Quite a past few months, eh? While not quite the chain of 25-sigma events the folks at Goldman Sachs think they saw, this summer was the most volatile the stock market's been in five years ... and the exotic hedging techniques we've invented over the past few years don't actually seem to be protecting anyone from anything.

As noted money manager Wally Weitz wrote in a recent shareholder letter, "These are the times that active money managers earn their fees."

Or are they the times that try men's souls?
Still, you don't need to be a professional money manager to start protecting your portfolio against short-term volatility and positioning it to achieve superior long-term returns. Many of the best money managers, including Wally Weitz, have achieved fantastic performance without doing anything quite so fancy.

Take Martin Whitman, for example. His Third Avenue Value (TAVFX) fund has crushed the market by more than six percentage points annually over the past five years, and it's trailed the S&P 500 index just once since 2000.

That's an incredible track record that we'd all be wise to replicate -- and Marty's happy to let us do so. In a recent shareholder letter, he revealed five of the key secrets to his success.

In no particular order
To be your own expert money manager, simply:

  1. Buy cheap.
  2. Buy quality.
  3. Buy to hold.
  4. Buy with minimal expenses.
  5. Buy without leverage.

If you can consistently follow all five of those tenets, you're on your way to making more money in the stock market -- and three of them are so simple that you'd be silly not to be doing them already.

The three easies
"Buy to hold" means sticking with stocks unless, as Whitman writes, "there has occurred a permanent impairment in underlying value" of a stock. Such an impairment may have occurred today, for example, for bond insurers MBIA (NYSE: MBI  ) and Ambac Financial (NYSE: ABK  ) when Berkshire Hathaway (NYSE: BRK-B  ) announced it would be entering that line of business. I'd also have to revisit my valuation of Starbucks (Nasdaq: SBUX  ) if China announced a cap on the number of stores the company could have in the country.

Having the patience and confidence to hold the stocks you buy through inevitable volatility (except when a permanent impairment has occurred) will automatically reduce your tax bill and trading expenses. Do even better by keeping commissions down to 1% to 2% of your investments.

Finally, don't invest money you can't afford to lose, and don't borrow money to invest. While leverage can increase your returns in good times, it will dramatically increase your losses in bad times. That's not the way to preserve capital and earn steady returns.

The harder two
Buying cheap and buying quality are more esoteric concepts. Put them together, and Whitman's essentially demanding that we all be smart investors.

But Whitman has a very clear definition of cheap: "Issues at prices that reflect substantial discounts from readily ascertainable NAVs [net asset values] ... [and whose] NAVs will increase by not less than 10% per year compounded." The classic Whitman example here is Brookfield Asset Management, which Whitman bought cheap, and which has returned 46% annually over the past five years.

To find stocks like Brookfield, start with companies such as Lehman Brothers (NYSE: LEH  ) , FEMSA (NYSE: FMX  ) , and Southwest Airlines (NYSE: LUV  ) , which are already trading for low-ish price-to-book multiples, and decide whether they're quality.

Easier said than done?
While quality will always be in the eye of the beholder, Whitman's definition is clear. It means having a strong financial position, competent management, and a business that is understandable.

Perhaps that's why Whitman has opened a position in homebuilder MDC Holdings. It's trading for book value, but it boasts $730 million in cash and more than 20% insider ownership, and it's poised to weather the real estate downturn.

Johnny 5 functioning 100%
At our Motley Fool Hidden Gems small-cap investing service, we follow every one of Whitman's tenets; not coincidentally, we share the opinion that MDC Holdings is a "buy." But we focus exclusively on small caps because we believe they represent one of the few sectors where individual investors can gain an informational advantage over institutional money.

While recent volatility has our small caps often running up or down 10% in a single day, our long-term returns have us 25 percentage points ahead of the market on average. That's what happens when you buy cheap, buy quality, and buy to hold.

You can take a look at all our Hidden Gems research and recommendations by joining the service free for 30 days. Click here for more information.

This article was first published on Aug. 23, 2007. It has been updated.

Tim Hanson owns shares of Third Avenue Value, Berkshire Hathaway, Starbucks, and FEMSA. The Motley Fool has an ownership stake in Berkshire Hathaway. Third Avenue is a Motley Fool Champion Funds recommendation. Berkshire and Starbucks are Motley Fool Stock Advisor recommendations. Berkshire is also an Inside Value pick. Brookfield Asset Management is a Global Gains pick. The Fool's disclosure policy puts a strong "buy" on Martin Miller's Gin.


Read/Post Comments (0) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

DocumentId: 557506, ~/Articles/ArticleHandler.aspx, 4/16/2014 6:22:38 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement