FOOL ON THE HILL
Own Just Two Stocks

Beating the market is by no means easy, but it can be done -- even if you have a busy life and only a few hours a week to devote to investing. The key is optimizing your research time. The "index plus a few" strategy is designed to maximize your time and abilities in structuring an easily managed portfolio with market-beating potential.

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By Matt Richey (TMF Matt)
August 27, 2002

After a long, hot summer where the stock market declined week after week, we're ready to get back to school -- or at least back to the basics of investing. Look for practical advice on how to shore up your portfolio all week. Today Matt Richey talks about having a concentrated portfolio.

Many investors enter the market with a preconceived notion of how many stocks they ought to own. Eight, 10, 15� sometimes more. Would you believe, however, that you might be better off owning just one or two individual stocks? And yes, this can be done without sacrificing diversification. Allow me to explain.

One of the most common pitfalls of individual investing is owning too many stocks. The problem is that, for too many investors, the number of stocks owned tends to be inversely correlated to the time spent researching any one company. That's a problem because an inadequately followed stock is a portfolio liability. Think about it: If you haven't done your homework on a company, you might be holding the next Enron or WorldCom. At the very least, your under-researched stocks are a gamble -- who's to say whether they have a real chance of beating the market?

Skimping on company homework is a recipe for picking market underperformers. Mr. Market may be manic-depressive at times, but he's no dummy. You need a knowledge advantage to win with stocks. Only by doing your homework on a company are you in a position to assess whether that company's stock represents a bargain.

Many investors try to escape the homework requirement by owning a whole bunch of stocks. "No single position can hurt me too much," they assume. Better rethink that. If owning one under-researched company is bad, owning 20 of them is definitely worse. (You moms out there might say that 20 wrongs don't equal one right.) Owning a basket of 20 under-researched stocks only increases your transaction costs, complicates your taxes, and exposes you to 20 separate chances to make haphazard investment decisions. Not a good scene. 

Index plus a few
There's a better way for the busy individual to approach portfolio management, a way distinguished by simplicity and logic. I call it 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. In the 13 Steps to Investing Foolishly, it would probably land at around Step 9, somewhere between straight-out index investing and a diversified portfolio of sturdy Rule Makers.

IPF is a simple, two-pronged portfolio strategy. The first prong stems from the fundamental goal of at least matching the stock market's average return. The easiest way to achieve this goal is to allocate a significant portion of your portfolio -- say, 80% to 90% -- to a total market index, such as Vanguard Total Stock Market Index Shares (AMEX: VTI). Vanguard Index Participation Equity Receipts (Vipers) trade just like an individual stock and almost exactly match the return of the broad-market Wilshire 5000 index.

The second prong of the IPF strategy is to allocate 10% to 20% of your portfolio to a few -- as in, one or two -- individual stocks. The idea here is to focus your limited research time on finding just one or two great stocks. The key in making these stock picks is to be highly selective -- only pull the trigger when you've found a company that you really understand and at a price that offers a mouth-watering risk/reward profile (lots of upside, little downside).

Combining the index foundation with a few well-selected stock picks results in an overall portfolio with market-beating potential. If you pick your stocks well, you should be able to boost your portfolio's overall return by 1% to 2%. For example, if the index portion of your portfolio returns 8%, and your two stock picks return 20%, then your portfolio's overall return would be 10.4% (assuming an 80/20 mix between the index and the individual stocks).

Beating the market by 2.4 percentage points may not sound like much, but accomplished over a few decades, it's enough to add tens of thousands, even hundreds of thousands of dollars to your retirement account. Not a bad deal for a few well-spent hours of company research each week.

Finding the "few"
The question becomes, how do you optimize your few hours of weekly research time to find those one or two marquee investment opportunities, which are admittedly few and far between? I see two possible starting points.

The first avenue is to look for opportunities among companies you know as a consumer. This is the classic buy-what-you-know approach made famous by former Fidelity Magellan Fund manager Peter Lynch. Investing in the companies that provide your favorite products and services is a natural way to make sure you're investing in a quality company.

If you're an avid consumer of a particular company, you'll be the first to know whether a new product is a hot seller or if quality has suffered a decline. These first-hand insights can be an excellent starting point for making smart investment decisions. The caveat to this approach is that your consumer instincts must only be used as a starting point. It's still incumbent upon you to analyze the financial statements and assess the valuation in order to make sure you're getting the stock at a reasonable price.

The second method for finding quality stock ideas is to utilize investment write-ups that appear in both online and offline financial publications. Fortune, Forbes, BusinessWeek, and, of course, Fool.com are just a few examples of the many free sources that offer stock analysis and opinions.

Not to be overly self-promotional, but if your time is particularly tight, and you're looking for the most convenient way to tap into a steady stream of new stock ideas, you may want to consider one of The Motley Fool's premium stock idea seminars or publications. Our Choosing Stocks With The Motley Fool online seminar ($49 for eight lessons) walks you through the stock-picking process. Motley Fool Stock Advisor ($99.95 per year) includes monthly insights and two recommendations per month in an easy-to-read format from the Fool's co-founders, David and Tom Gardner; and The Motley Fool Select ($149 per year) offers in-depth analysis and three recommendations per month from The Motley Fool's research team (myself included).

Optimize your research efforts
Once you have a few starting points for investment ideas, make it your goal to spend the bulk of your time on your own hands-on research. Even with just a few hours per week, you can make it count by looking at companies one at a time and digging deep.

Here's a one-month sample research approach that would require only one to two hours per week. In week one, read the annual report. In week two, read the past several quarterly earnings releases and/or 10-Q filings. In week three, analyze the financial statements. And in week four, listen to the most recent quarterly conference call. After a month, you'll know the company pretty well.

This type of in-depth research 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 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 10% to 20% of your portfolio to these holdings. As long as you pick a quality company and pay a reasonable price, there's no reason to be afraid of allocating 5% to 10% of your savings to a single stock holding.

Consider the advantages
I see four standout advantages to the IPF approach:

1. Carefully managed risk -- The idea of reducing risk by owning fewer stocks is admittedly quite contrary to the traditional admonishment, "Don't put all your eggs in one basket." I stand with Warren Buffett in my belief that it's better to have just a few baskets and watch those baskets very carefully. The underlying logic here is that risk is minimized through in-depth research. You can't beat the diversification of the Vanguard Total Market Index, and your concentrated bets on a few companies are bolstered by deep knowledge. As long as you have a genuinely rock-solid understanding of why your one or two companies are poised for an increase in value, then your portfolio isn't any riskier than the market as a whole.

2. Cost efficiency -- By owning only a few individual stock holdings -- including the Vipers -- your transaction costs will be minimized. At $8 per trade, buying the Vipers plus two additional stocks would only cost you $24 upfront. Additionally, the expense ratio on the Vipers is only 0.15%, which translates to a cost of only $15 per year on a $10,000 investment. With costs totaling as little as $39 ($24 in commissions plus $15 for the Vipers' fund expenses), this is an ideal approach for beginners or new savers. You could get started with the IPF strategy on a pool of savings as small as $4,000 and keep your expenses under 1%.

3. Simplicity -- The simplicity of this strategy minimizes your time-opportunity costs. By focusing your research efforts on a few carefully selected companies, you'll have more time to get out from behind the computer to actually live a little! Plus, IPF keeps your taxes simple. Also, unlike a mutual fund, which distributes annual capital gains taxes, Vipers (as well as other index shares) are taxed 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 this simple portfolio strategy.

4. Accountability to your benchmark -- The final advantage of the IPF strategy is that having the Total Market Index as part of your portfolio helps keep you accountable to your benchmark. If, by chance, your individual companies don't outperform the Vipers over a period of three or so years, you might want to consider 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 at reasonable prices, they'll be long-term outperformers.

Conclusion
If your current 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.

Matt Richey is a senior investment analyst for The Motley Fool. At time of publication, he had no position in any of the companies mentioned in this article. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.