Fool.com: The "Index Plus a Few" Strategy[Fool on the Hill] April 25, 2000

FOOL ON THE HILL
An Investment Opinion

The "Index Plus a Few" Strategy

By Matt Richey (TMF Verve)
April 25, 2000

"That one's mine. So is that one. Yep, I own that one, too."
-CNBC commercial for its personalized stock ticker

I think one of the most common pitfalls of individual investing is owning too many stocks. Is it any wonder? Vying for our investment dollars, we find so many alluring revolutionary companies in biotechnology, optical networking, and wireless communications, plus another set of appealing market stalwarts in beverages, mass market software, computer chips, pharmaceuticals, and financial services. A stock here, a stock there... before you know it, you own representatives of most every major industry, and by virtue, the market itself.

Even if this type of strategy produces market-beating gains, it's a strategy encumbered by numerous transaction costs, substantial record keeping, and an obligation to track the progress of all these companies on a quarterly basis. Below, I propose an alternative way to beat the market, a way distinguished by simplicity and logic, which I call the "Index Plus a Few" strategy, hereafter simply IPF.

As the name implies, IPF is a hybrid strategy mixing the best aspects of index funds and individual stocks. On the 13 Steps to Investing Foolishly, it'd probably land around Step 9, somewhere between straight-out index investing and a diversified portfolio of Rule Makers.

IPF is a simple two-pronged portfolio strategy. The first prong stems from our fundamental goal as investors of at least matching the average return of the S&P 500. The easiest way of achieving this goal is to allocate a significant portion of the portfolio -- say, 60-80% -- to S&P 500 Unit Depositary Receipts (SPDRs) (AMEX: SPY). "Spiders," as they're called, trade just like an individual stock and exactly match the return of the S&P 500.

The second prong, which is aimed at extending our returns beyond the market's average, is to allocate 20-40% of the portfolio to a few -- as in, one or two -- individual companies. The key here is identifying truly great companies, just one or two that you know inside and out, and that have the potential to be market-beating long-term winners.

How do you find these companies which are, admittedly, few and far between? Intellectual curiosity and plenty of reading of all things business-related go a long way in separating the wheat from the chaff. This strategy relies upon an upfront investment of time in studying industries, business models, and management. In a recent interview with the Fool, Yahoo!'s CEO Tim Koogle identified four key questions to ask yourself as you consider a company's investment merit:

1) Is the company, or can it be, a leader in its market?
2) Is it addressing a market that's truly big and growing fast?
3) Is the fundamental business model a good one so that it can actually become cash flow positive and achieve profitability?
4) Is it well managed?

Together, those rather simple questions get to the heart of whether a company has the ability to build shareholder wealth over a period of not just years, but maybe even decades.

To answer those questions, you need to really understand a company through and through. When you identify a potential winner, you'll want to concentrate your investment study and dig deep to learn as much as possible about the underlying business. You'll want to read the annual report, read the quarterly earnings releases, crunch the quarterly numbers, assess the valuation, listen to the quarterly conference calls, use the company's product/service, read articles and books related to your company, read the quarterly 10-Q and annual 10-K SEC filings (including the footnotes), scour the company website, and read the company's Fool discussion board. Whew! That's a lot, yes, but if business fascinates you, and you love to learn, then this stuff actually should be a lot of fun.

Doing these things will provide you with a thorough understanding of a company's industry attractiveness, its position in the industry, and its business quality. These specific insights on just one or two companies are what will give your IPF portfolio its market-beating ability. Let me emphasize that you should know these one or two companies so well that you don't have any fear in allocating 20-40% of your portfolio to these holdings.

An IPF portfolio is actually a low-risk strategy, too. You can't beat the diversification of an index, and your concentrated bets on a few companies are bolstered by deep knowledge. My favorite definition of risk is that risk is not knowing what you're doing. As long as you have a genuinely rock-solid understanding of why your one or two companies are poised for long-term success, then your portfolio isn't any riskier than the market as a whole. Fool, this strategy is totally contrary to conventional Wall Street Wisdom, but I think allocating a major portion of your portfolio to a few companies that you know exceedingly well is the easiest way to beat the market.

Further, this strategy has many other attractive benefits. First among these is cost efficiency. By owning only two or three holdings -- including the SPDRs -- your transaction costs will be minimized. Additionally, the expense ratio on the SPDRs is only 0.18%, which translates to a cost of only $18 per year on a $10,000 investment.

Second, the simplicity of this strategy minimizes your time opportunity costs. By focusing your efforts on a few outstanding companies, you'll have more time for getting out from behind the derned computer to actually live a little!

Third, the tax advantages of only keeping track of a few holdings is a great burden off your shoulders. Also, unlike a mutual fund, which distributes annual capital gains taxes, SPDRs (as well as other index shares) are taxed just like a regular stock, so you control when taxable gains or losses are recognized. Many investors would have no need for an accountant come tax time if they employed a simple portfolio strategy such as this.

Fourth, the IPF strategy is ideal for "capital challenged" investors, such as 20-somethings like myself. Even if you don't have much money, you don't have to worry about transaction costs eating away at your principle with this strategy. At $10 a trade, you could start with as little as $2,000 and keep your transaction costs to around 1%, based on two buys: the SPDR shares and one well-researched individual company.

The final advantage of the IPF strategy is that having the S&P 500 as part of your portfolio helps keep you accountable to your benchmark. If, by chance, your individual companies don't outperform the SPDRs over a period of three or so years, you might want to give thought to allocating 100% of your funds to the index. Heck, if you can't beat 'em, join 'em. Chances are, though, if you really do your homework and uncover one or two outstanding companies with great management, prospects for global leadership, and a secure business model, then they'll be long-term outperformers.

So, if your portfolio more closely resembles a stock collection than a deliberately designed portfolio, and if you're attracted to a simple, efficient, and rigorously logical way to beat the market, then you might want to consider restructuring your portfolio with the IPF in mind.

Related Links:

  • Diversification Isn't All That
  • Index Shares Overview
  • S&P 500 "Spiders"
  • Nasdaq 100 Index Tracking Stock