Reducing Risk: 2002 and Beyond

When he looks at his investing mistakes over the last few years, Tom Jacobs identifies three culprits: too large a percentage of speculative investments, a failure to properly value each investment and have a sell strategy, and insufficient knowledge of key financial statement items. In his next three Thursday columns, Tom shares his plan of attack. Today: risky investments.

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By Tom Jacobs (TMF Tom9)
December 26, 2002

Readers over the years know I've been only too happy to tout my investing mishaps while not showcasing my successes. Yet in a world that wants gurus, isn't that bad for business?  

Exactly the opposite is true. You can learn as much -- or more -- from the poor investment decisions as you can from the better ones. Human nature is such that people are more likely to extol successes, but not always tell the truth about failures. Sure, we might roll our eyes and nod in sympathy when someone talks about the last three years of general market declines, but how often do we go farther, to: "I bought High Flyer at $100 a share and watched it fall to $5," and then to what really matters: "Why did that happen?"

I'm not saying the decision to actually buy or sell stocks is a group sport, but without a doubt, investing education can be encouraged by learning together. That's why I value our discussion board community (free trial available) and my TMF colleagues. So in the spirit of true Foolishness, here's what investing in 1999-2001 taught me: 

  • I put too large a percentage of my portfolio into risky, speculative investments.
  • I didn't really understand valuation. This left me with a weak sell strategy, uncertain if or when to act.
  • I didn't understand certain key parts of financial statements enough.

I attacked each one of these head-on in 2002 and will continue in 2003 and beyond. This and my next two Fool on the Hill columns will treat each one in turn, with specific examples of stocks bought and sold.

Too large a percentage in risky stocks
Each of us must decide our comfort level with speculation -- investing in stocks that present great risk. This category includes what we, at The Motley Fool, call Rule Breakers -- stocks that are first movers and top dogs in important, emerging industries, or that are trying to revolutionize existing ones. This included, at one time, such companies as Amazon (Nasdaq: AMZN), eBay (Nasdaq: EBAY), and Yahoo! (Nasdaq: YHOO), as well as many other Internet e-commerce,  biotechnology, and Internet infrastructure companies. You need never own a newer, development-stage company, but if you do take on this risk, it's best to keep it to a small part of your portfolio. 

There is no hard and fast rule about how small a part, but we've written in our Rule Breaker portfolio columns and in various Motley Fool books that newer investors should keep their percentage of Rule Breaker-type stocks to 20% or less of their portfolios. And that doesn't mean if one succeeds wildly, you sell it to bring the percentage down, either. It may mean that company has succeeded and, depending on its valuation, is now actually less risky. Your research, investing goals, and individual psychology will determine your allocation. 

At the beginning of this year, I had way more than 20% in risky stocks -- and not because any one was a great success. I had been seduced in earlier years by high-growth companies with great prospects, and didn't  understand that they were speculations. Or that if they were succeeding, their valuations were already so high that many years of future profits were already accounted for in price.

In 2002, I cleaned out some that I either didn't understand or that no longer presented the prospects for huge returns to compensate for the risk, and I increased my percentage of lower-risk stocks and value stocks. I didn't just sell and look around, either. I sold because I already had alternatives that I thought presented better risk-reward calculations. 

Sold or reduced these stocks
Last year, I sold all my shares of Cree (Nasdaq: CREE) at an average price of $27.00 for about a 30% loss. I found that while I understood the company's business whenever I was studying it, I couldn't then remember it well enough or condense it clearly enough to tell someone later -- a test Peter Lynch recommends. I also sold two biotechnology investments, Medarex (Nasdaq: MEDX) and Celera Genomics (NYSE: CRA) -- the first at a substantial loss, and the second at about even. Medarex had consistently failed to live up to management promises, and Celera was no longer was the business I bought several years ago. I didn't want to own the one it became, either.

I reduced the percentage of my portfolio invested in two favorite but risky companies, network controls company Echelon (Nasdaq: ELON) and computer memory designer Rambus (Nasdaq: RMBS), taking 30% losses. I maintain and intend to keep 5% positions as their businesses develop over the next few years. These companies employ complex technology, and there is a great risk each could be superceded or never take hold in the first place. Yet their business models are very clear, and reading the quarterly reports easily reveals their progress -- or lack of it.

What we own, you see
We Motley Fool employees show the world our holdings in our profiles. In mine, you will see far more risky stocks than not -- those already mentioned, plus chip design company ARM Holdings (Nasdaq: ARMHY), advanced materials and energy innovator Energy Conversion Devices (Nasdaq: ENER), online lending exchange LendingTree (Nasdaq: TREE), OLED designer Universal Display (Nasdaq: PANL), and biotech drug makers ISIS Pharmaceuticals (Nasdaq: ISIS)Millennium Pharmaceuticals (Nasdaq: MLNM), and Ligand Pharmaceuticals (Nasdaq: LGND)

Yet because each is a small percentage of the portfolio, my total risky stock percentage -- including the value of small short positions in music retailer Guitar Center (Nasdaq: GTRC), Intel (Nasdaq: INTC), and specialty retailer Panera Bread (Nasdaq: PNRA) -- is now between 20% and 30%. This is still too high for most people, and certainly at my personal limit. But it's down from before, and at my age and situation (46, coupled with no dependents and no debt, other than a mortgage of about one-third of home value), I can sleep at night. Those with dependents and those closer to retirement rightly eschew this allocation. Your mileage will vary.   

I do like to take risks -- I've even experimented with put options with less than 2% of my portfolio after reading Zeke Ashton's two-part series over the summer in The Motley Fool Select. (Warning: Shorting stocks and buying or selling options are for experienced investors only. Neither is necessary for investing success, happiness, or health. We firmly believe that it's best to present information for all ranges of investors, and that each individual is then in the best position to make informed choices.)

But I try to recognize my risk-tolerant psychology and manage it by keeping risky stocks to a smaller part of my portfolio than before, and to keep the really risky stuff (shorting, options) to just a very small part of that. I suspect that the 20% to 30% portion will decline even farther in 2003, unless some of the businesses succeed and their stocks appreciate disproportionately to the rest of the portfolio. 

Value investments
I had found better investments that represented less risk and bought deep value stocks like ValueClick (Nasdaq: VCLK), selling at a substantial discount to cash with little or no cash burn and management steadily buying back shares. I also bought medical systems software maker Quality Systems (Nasdaq: QSII)discount clothing retailer Sportsmans Guide (Nasdaq: SGDE), and Christian media company Integrity (Nasdaq: ITGR)(each of these was featured over the last year either in Select or the predecessor to Stocks 2003.), all selling for low price-to-free cash flow multiples measured against their ability to keep churning out the green stuff. 

My dumbest move? I thought that Belgium-based automobile logistics transporter ACLN was clearly a deep value stock. Sadly, it turned out to be a fraud, and I sold for a huge loss. A company is no more or less likely to be a fraud if it files financials here or elsewhere, but more frequent filings under U.S. Generally Accepted Accounting Principles simply provide more information and a better chance to see problems. That's why today the only company I own that doesn't file U.S. financials each quarter is ARM Holdings -- a risky stock mentioned above, and I'm tracking that one closely. I'll deal with financial-statement savvy in the third and final column of this series.

Today, I have about 30% of my portfolio in this category, happy to let this expand according to the stocks' hoped-for success, with some idea about what a sensible valuation is. Valuation and selling are the focus of the next column.

Big and lumbering
I increased the percentage of my portfolio devoted to what I believe to be solid but unsexy stock investments to 40% to 50%. This includes individual stocks and an S&P 500 index fund. Because I max out my 401(k) contribution and invest it in the S&P 500 fund, the percentage of my overall portfolio invested in risky stocks will decline naturally over time -- unless one of the risks pays off.

This group also includes about a third in cash -- 15% of my portfolio value -- because I haven't found the right places for it. I did find two investments and purchased them for my Roth and rollover IRA (I rolled over my 401(k) from my former employer into an IRA when I joined The Motley Fool in July 2000). These two consistent dividend-paying stocks are tobacco and consumer products company Philip Morris (NYSE: MO) and smokeless tobacco maker UST (NYSE: UST). The dividends are tax free in IRAs.

I'm also looking at dominant companies, such as debt-quality evaluator Moody's (NYSE: MCO) and diversified health-care products giant Johnson & Johnson (NYSE: JNJ). Both are approaching attractive valuations, but I need to do more research before buying. Other companies dominating their industries attract me but are highly priced. Wireless technology licensor and manufacturer Qualcomm (Nasdaq: QCOM) and eBay would entice me in the low 20s, as would Starbucks (Nasdaq: SBUX) in the mid to low teens.  

Frankly, I may never get the chance to see any of these stocks at prices I want, proving me unwise in the long run. Sometimes you have to pay up for quality. Perhaps that's the fourth lesson, but right now, I'm busy with the first three, thank you very much.  

Notice that I didn't just panic and sell everything. I cringe when I see these stories in major financial publications. I had a plan this year to reduce my Rule Breaker percentage, and as the year progressed, I carried out the plan. It involved learning more about valuation, selling, and financial statements, which I take up in columns the next two Thursdays.

With all best wishes for the New Year, I remain yours in Fooldom,
Tom Jacobs (TMF Tom9 on our discussion boards)

Tom Jacobs (TMF Tom9) and The Motley Fool analyst team deliver their 11 best stock ideas for the year ahead in Stocks 2003 -- available now! Tom also provides an idea for a stock to short this month in The Motley Fool Select. Start your 30-day free trial today! He disclosed his holdings in this article, and follows The Motley Fool's disclosure policy.