RULE MAKER PORTFOLIO
Step 8: Company Ownership and Partnership

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11 Rule Maker Steps

Patience is a necessary ingredient of genius.
-- Benjamin Disraeli

Remember our comparison between buying stock and buying a house, earlier in this collection of articles. It's a viewpoint you probably won't see from your stockbroker any time soon. When you buy a home, resale value may be somewhere in the back of your mind but, for most people, it's not the primary reason to buy. Most folks buy a house and plan to live there for ten years, at least. We think that's how you should approach the stock market and your investment portfolio.

Again, that's not the way most stockbrokers on Wall Street want you to think. Not at all. Why? Because over 80% of a retail broker's business is tied to commission cuts off transactions. They want you to buy and sell houses every month, every week, every day if possible... because under the present system, that's how they get paid. If you didn't know it before clicking into this collection of articles, you now know why brokers "cold-call" investors with stock recommendations. You now know why that college buddy of yours at Smith Hutton, who manages your money, calls you once a week suggesting a few changes.

Commissions!

Now it may seem like I'm being hard on stockbrokers, and I suppose I am. So let me say right now I have nothing against these guys -- oddly enough, most of them are guys. But I would like to dispel a persistent myth that the financial media still believes and one that costs a lot of people a lot of money: Stockbrokers are not naturally good sources of investment advice.

A stockbroker is about as likely to be good at investing your money as the person working the cash register at a restaurant is likely to be an excellent chef, or the saleswoman at a bookstore is likely to be a bestselling author. It may happen, once every 50,000 people... but that's not what they've been trained to do. Brokers are not trained primarily to research businesses and maximize the value of your portfolio. They're trained to sell you investment products -- some good ones, some mediocre ones, some ridiculously inappropriate ones. And the quality of these investment products isn't half so important as the sale of them is.

Consider this. Most brokers will tell you it's a good idea to:

  1. sell your shares if you think the market's headed down
  2. buy them back again at the lower price
And this absolutely, positively, 100% guarantees that you'll make money...

for your stockbroker.

Ya see, if you make those trades, they and their firm are guaranteed a commission -- at full-service firms, a commission of up to $500 and beyond. It's a great deal for them. They assume none of the performance risk for your investments, but take a consistent and substantial reward for your shouldering the risks! Great business model. That is, until Foolishness found the Internet and hundreds of thousands of people gathered together to talk about it.

The Rule Maker model to investing, and the online portoflio, are concentrated intently on minimizing the overall cost of investing while maximizing returns over time. Our experience has been that most Americans have years and decades before they retire. They needn't rush, and they needn't trade frequently. They needn't tirelessly kick out commissions to an investment firm. They needn't dole out 30% of annual investment profits to the government in capital-gains taxes. Each and every year. With that model, you were often lucky just to break even. No kidding. And all the while, a guy named Warren Buffett (and guys and gals like him) were racking up unbelievable returns just by buying and holding great companies. They became partners with the companies they invested in.

Fool, please understand that the single greatest way to make your stockbroker happy is to tell him that you'd like to begin day-trading some of your portfolio! This isn't to say it's impossible to make money as a "day trader" (someone who buys stock and sells it again later the same day), but if you want to risk your money where the odds are stacked against you, go to Las Vegas. At least there you get free food and a floor show and a water bed. If you're just beginning to invest, here's one of my favorite rules of the game: "No matter how idiotic an investing idea is, somebody out there who can get rich off advocating it will do so." Las Vegas, the state lottery, day trading, options trading, buying gold coins advertised on the radio... you'd save far more money encouraging your enemies to buy into these than doing so yourself.

So, are we saying not to invest in anything ever that anyone recommends. . and thus, never to buy stocks talked about in an investment club or ones that your Dad likes? No, no. You might not believe it -- given how thoroughly the brokerage community has taken advantage of Americans over the past two decades -- but the stock market, by its very nature, stacks the deck in your favor. Public companies exist to make their direct shareholders money. They are owned by the public. They perform for the public. They are successful in large part because of the public's investment in their business. And on average this century, they have returned investors 11% per year -- far outpacing the returns of any other investment vehicle.

Every year the best of these corporations are trying very hard to grow their profits, for you. After all, the money they make belongs to the owners of the company -- the stockholders who literally bought a portion of the business in just the same way that they could own a piece of a timeshare in Bermuda or shares of a minor-league baseball team. If you own 100 shares of a company that earned a dollar per share last year, that company made $100 profit for you, without you having to lift a finger. Can you run that math quickly with us? 100 shares owned. $1 of profit per share. $100 of profit for you.

Since that $100 profit I just mentioned is your money, the company could simply mail you a check. This happens all the time. It's called a cash dividend. In this case, you'd get four checks during the year for $25 each, since most companies pay their dividends in quarterly (every-three-month) allotments. And, again, you didn't even have to get up off your couch, you lug. You invested and checks came back in the mail to you. But, if it's that easy, why don't all the companies that you invest in mail their profits to you in the form of dividend checks? Because many companies see an opportunity to use that $100 of your profit to further grow their business. They are aiming to, say in five years, mail you a check for $225 per year. They've decided to use today's profits to invest in tomorrow.

Now hold on there - who makes the decision to invest those profits? Ostensibly, the executive team that shareholders have helped to appoint each year. But, in truth, shareholders make the decision. They own the company - literally. If the owners of 50% of the shares of Philip Morris Inc. showed up at the annual meeting and said "Guys, stop selling cigarettes internationally,"... it would happen.

It works like this. . .

Companies have an Annual Meeting. Anybody who owns even one share is invited to show up, eat the free food, listen to management campaign to stay in office, step up to the microphone and ask pointed questions, and of course vote on things. Companies are very economically democratic. Each share of common stock that you own gives you one vote. The more shares that you own, the more votes you have. Since a lot of decisions can't wait until the next annual meeting, the shareholders elect a group of people called the "Board of Directors" to make decisions for the company during the rest of the year. The Board of Directors tends to consist of the largest shareholders (or their representatives), on the theory that anybody who can vote for themselves a million times will probably get elected.

But the Board of Directors doesn't meet every day. Some meet once a month, others just gather at each Annual Meeting. That's because it's extremely hard to actually run anything by committee. No, the board's job is just to help provide a framework for the company to use in its daily operations. Thus, its main job is to appoint officers or executives to actually run the business' day-to-day activites. You may have heard of some of the managers that they help to employ: the Chief Executive Officer (CEO), the Chief Operating Officer (COO), the Chief Information Officer (CIO), the Chief Financial Officer (CFO), et cetera. The office of the CEO - usually one, but occasionally up to a few people - answers directly to the Board of Directors. And the Board of Directors answers to the shareholders, the owners of the company.

Ok, there's some structure for you, but let's get back to following the money. That's a good deal more fun.

Before we started talking about the Board of Directors, we asked you: What can give more bang for the buck than simply mailing a dividend check back to investors? The answer: Growing the company with those profits. Suppose your company spends your money to buy you new factories, hire more people to work for you, advertise your products more, maybe even buy other companies. (By the way, we imagine it does sound strange to read "your company" over and again... but that's what it is.) Generally, your company can invest in itself to grow into an even bigger business, making you more money this year, attracting more and more people to want to own a share of that business. Your share. And as that happens, the value of your stock rises.

Hold on, though, you need to know something else. The stock market isn't always a rational thing. In fact, today, tomorrow, next week -- in the short term -- the stock market is driven by emotion, by personality, often by everything but a search for the true underlying value of a business. So... even as your company grows its profits tomorrow, its stock price might fall. How?

In a public market, the price of things is determined by what the people are willing to pay for them. Thus, stock prices can flit and flutter around the fair value of a business like a bungee jumper in a hurricane or a butterfly in a windstorm. Sometimes the stock of your company might be a real bargain. Other times it would seem to cost an arm and a leg (and a couple of internal organs) to pick up more shares. Figuring out which of these is the case isn't easy. But in our experience, the farther that price diverges from fair value, the harder the bungee pulls it back -- snapping prices from one extreme to the other in the short-term. Ahh, the short-term. Thankfully, we're concentrated on the long-term. The 20th century has shown that if the true underlying value of a company goes up, eventually the price of the shares of that company rise up to meet it.

The whole idea behind the Rule Maker approach is based on that notion.

Thus, again, we will largely ignore the weekly fluctuation of stock prices and, instead, concentrate on the merits and shortcomings of the actual business. If you can find the best managed, most profitable companies with increasing potential... tomorrow morning's share price shouldn't concern you. Have breakfast with your husband. Or give your grandmother a call. Or read your morning paper. Or play with your kids before school. But don't sweat the daily wiggles of your company's stock, charted on a graph digitized on the Internet, or spinning past you on a television screen.

Now, as I wrote in the beginning of this Eighth Step to Investing in Rule Makers, that sort of long-term sensibility runs directly opposite to what most brokers suggest you do with your money. Oh well. Time will lay that business model to rest. Meanwhile, you can take charge of your account. I mean, if you had $1,000 to invest, or $10,000 or $100,000, would it be smart to repeatedly pay $200 commissions to dance from stock to stock? Only then to pay taxes on every gain at year-end? Is that a good way to invest - paying everyone around you as much as you can? We don't think so.

Rather than that, consider what happens if you can find a company that grows earnings and its stock at an annual rate of 13% per year over the next 40 years. At that rate, an initial investment of $5,000 blooms into... $664,000. And that figure doesn't include your adding any money along the way -- which ain't going to happen, right? Now, you don't get those great performance numbers if you pay heavy commissions and ongoing tax payments.

Our aim here in the Rule Maker portfolio is to find companies that we want to own, with whom we want to be partners, perhaps for the remainder of our lives. When we find them, we half-lash ourselves to the mast and hang on for the ride. Some of our investments will perform poorly; others, moderately well; and some we expect will dominate. That mix should turn our $20,000 literally into millions of dollars in a handful of decades. And we think millions of bucks in a few decades will have us living large (and sharing much) on a spacestation floating 'round Galileo's moons.

Accordingly, we'll let the Wise on Wall Street try to beat the market averages by predicting where stocks are headed tomorrow and then the next day. We'll let the Wise experts at financial publications promote the greatest eight investments for the next three months. But, here in CK land, we mere common Fools will be looking out as far as the eye can see. Even much farther than that.

We're in for a penny and in for a pound.

Step 9: Putting It All Together »