Motley Fool Staff
Updated: Dec 21, 2016 at 5:20PM
Published: Jan 10, 2000 at 12:00AM
For those of you who didn't read Friday's column, here is a quick link if you want to go back and catch up on what you missed. The rest of us will wait here until you're finished....
OK, now that we're all caught up, let's move on to what I consider the meat and potatoes (or, if you're vegetarian, the soy protein and potatoes) of any Foolish portfolio: our beloved Rule Makers. By keeping a big portion of Rule Makers in your portfolio, and even better, by dollar cost averaging into them, you'll likely beat the S&P 500 while spending an average of five hours or so a month in maintaining your portfolio. Because the Rule Maker philosophy is a very long-term, low-turnover strategy, Rule Makers are perfect for the taxable portion of your portfolio. For illustration purposes, here is how a Fool might combine index and mechanical strategies with Rule Maker investing to attain a very tax-efficient portfolio.
- 50% S&P 500 Index fund or Spiders (AMEX: SPY)
- 25% Nasdaq 100 Index Trust (AMEX: QQQ)
- 25% Beating the S&P (an alternative to the Foolish Four)
- 100% Rule Maker
Let's talk about the risk and time/effort characteristics of a Rule Maker portfolio. Both the risk and the time requirements depend on how many Rule Maker stocks you have in your portfolio. I recommend that for each Rule Maker holding, you at least print out and review the company's financial reports every quarter, and then spend some extra time reading the company's annual report when it gets mailed to you. This is about an hour per fiscal quarter for each Rule Maker stock in your portfolio. If you have five stocks, you can probably spend as little as five hours per quarter maintaining your portfolio. If you have 10, you're talking about twice that amount of time. Remember, I'm talking about the minimum effort here. If you are actively looking for new Rule Maker companies to invest in, you will likely spend quite a bit more time than that.
As far as risk is concerned, I'd characterize Rule Maker investing as slightly more risky than investing in an index fund. You can reduce risk in your Rule Maker portfolio by two ways: 1) dollar cost averaging, which means buying consistently into the market at given intervals, whether it be monthly, bimonthly, quarterly, or whatever; and 2) increasing the number of stocks in your portfolio. Adding stocks to lower risk will only work, however, if you ensure that you don't sacrifice quality to achieve diversity. Also, you'll generally find that the benefit of additional diversification starts to diminish once you go beyond 10 stocks, assuming you have at least three or four industries represented.
In our online portfolio, for example, we currently are invested in only 10 stocks. We may add one or two new ones this year, but in general I think that we're pretty comfortable with that number. Cisco, Yahoo!, Microsoft, and Intel represent various industries within the technology sector; American Express and T. Rowe Price are financial services companies; Pfizer and Schering-Plough are pharmaceutical companies; and we have Gap Stores and Coca-Cola that manufacturer and sell consumer products. That's quite a bit of diversity achieved with just 10 stocks. Of course, all of our companies are global brands, which means that all are geographically diversified as well.
To this point, the Unified Fool Portfolio consists of index products, a mechanical strategy or two, and some world-beating Rule Maker companies. By dollar cost averaging into this portfolio, we'll stand an excellent chance of beating the major market indexes, and we'll also be very miserly when it comes to taxes and transaction costs. But where's the adventure, you say? Is consistent market-beating performance not impressing your friends at cocktail parties? You want to take on a little more risk, add some thrills, and go hunting for some high-return Rule Breakers? No problem. With the core portfolio we've constructed so far, adding one or two bona fide Rule Breakers to the portfolio won't increase your risk much, and will add some high growth potential.
Rule Breaker investing requires a complete change in mind-set from standard Rule Maker investing, but in general you're looking for smaller companies with the potential to become Rule Makers. If you find just one company that goes from Breaker to Maker, you'll likely increase the value of your investment by 10 times or more. This can be enough to pull the return of your entire portfolio up substantially. Those amazing Fools over in the Rule Breaker portfolio have been uncanny in their ability to identify potential Rule Makers early on in their corporate lives. Both AOL and Amgen now qualify as bona fide Rule Makers in my opinion, and Amazon is clearly the big dog in e-tailing. To discover how they do it, mosey on over to the Rule Breaker Portfolio. (Alternatively, David Gardner will be hosting a 10-lesson interactive online seminar on the Rule Breaker investment approach in late February. If you'd like more details on what's included, what it costs, and how to sign up, drop a note with the subject line "Tell Me More" to email@example.com.)
Once you've decided you want to add some Rule Breakers, how best to do it? I believe that Rule Breaker investing requires quite a bit of time and effort and an uncompromising standard of quality to pay off. Once a Rule Breaker has been identified and purchased, it then requires immense fortitude to hold through the inevitable volatility that follows. Because I spend most of my time looking for Rule Makers, I don't actively search out the Rule Breakers. About once or twice a year, however, I come across a company that I think has the potential to break the rules of its industry. In these cases, I do my research, and if I'm convinced, I'll pull the trigger. Here's where Rule Breaker investing might fit in to a Unified Fool Portfolio:
- 50% S&P 500 Index fund or Spiders
- 25% Nasdaq 100 Index Trust
- 25% Beating the S&P
- 80% Rule Maker
- 20% Rule Breaker
If your risk tolerance is higher and you find you have the right mentality for Rule Breaker investing, you can raise the percentage accordingly. To achieve and maintain the above portfolio likely requires a minimum of about five hours a month, which pretty much makes investing a minor hobby. For those Fools who discover they love the research and the thrill of finding great investments, you can move on to our two strategies for advanced investors: small-cap growth companies and value investing.
I'll start with our Foolish approach to small-cap growth company investing, called the Foolish 8. These eight criteria were outlined by Foolmeisters Dave and Tom Gardner in The Motley Fool Investment Guide. In short, the Foolish 8 is a very effective method for identifying fast-growing smaller companies before Wall Street discovers them. You can use these criteria to find candidates yourself, or you can subscribe to our Foolish 8 Spreadsheet, and we'll send you a list, updated monthly.
The Foolish 8 is for investors who are willing to do a lot of research and are very comfortable investing in small companies, many of which are too small for Wall Street's comfort. The stock prices of these small companies also tend to get blown around like a gnat in the wind, which can make some investors queasy. The reward for the investor's efforts are potentially very high returns. This is a very time-intensive pursuit, however, because the work isn't over once you've made your purchase. No siree, you've got to watch those little suckers pretty closely, because small fish can get munched by larger competitors, especially if the little guy has got a good thing going.
Personally, I have had very good results by using the Foolish 8 as a list of candidates, and purchasing only the three or four per year that really attract me. Of course, I've had some blowups, but overall this has been the highest performing portion of my portfolio. As far as portfolio allocation, I don't have a preordained allocation of my portfolio, but rather just add them if they are the most compelling investment at the time. Here is a sample of how a Fool could mix in these small-cap growth stocks to his or her portfolio:
- 25% S&P 500 Index fund or Spiders
- 25% Nasdaq 100 Index Trust
- 25% Beating the S&P
- 25% Rule Maker
- 60% Rule Maker
- 20% Rule Breaker
- 20% Foolish 8
Finally, what I consider to be the most advanced strategy of all -- value investing. Value investing, as practiced in our own Boring Portfolio, consists of purchasing shares of good companies when they are selling at a price that offers a discount to the company's intrinsic value. Unlike the Rule Maker and Rule Breaker portfolios, which don't focus a lot of time on valuing companies, value investing places the major emphasis on valuing companies in order to identify those that are compelling investments. Investments are usually made only when the price-to-value equation makes the investment a "lay-up," or in non-sports parlance, a high percentage bet. Because this doesn't happen often, especially in today's pricing environment, the value investor is often compelled to run a very concentrated portfolio.
The value investing approach appeals to very quantitative investors who are confident not only in assessing the quality of a business, but also in establishing a range of value for that business. As a general rule, the risk of the individual stock purchases is theoretically lower than normal, because a value investor demands a margin of safety in the price. In practice, however, I would classify the risk as midlevel due to the resulting portfolio concentration. Warren Buffett has been known to hold as few as three stocks in his portfolio, and our own former Bore manager Dale Wettlaufer was carrying only four holdings.
To conclude, I hope that I have given you some food for thought as to how you can combine the best ideas of The Motley Fool in a customized way to your own portfolio. If you use all the strategies simultaneously, you are probably talking about 10 to 20 hours per month of research. I find that by dollar cost averaging every month, simply taking the single best idea I have at the moment allows me to keep time constraints from being a problem. If I have no time one month, I just go with the Nasdaq 100 or with an existing Rule Maker. If I have more time in a given month to do research, I'll spend it looking into the Foolish 8 stocks or for a new Rule Maker or Breaker. As a general rule, I keep the total number of investments to no more than 20 at a given time.
If you have thoughts on creating a Unified Fool Portfolio, let us hear from you on the Rule Maker Strategy message board.
Y'all stay Foolish!
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