On Monday, I presented the five-year results of the Simpleton Portfolio, Tom Gardner's original 1995 brainchild that eventually led to our modern Rule Maker Portfolio. To recap, the ten-stock Simpleton has lapped the S&P 500 almost ten times over -- without any trading, taxes, or hand-wringing of any kind. Today, let's look at what lessons have emerged from Tom's second attempt at a ten-stock, ten-year portfolio, this one set forth in mid-1997 and named the Money-Heavy Portfolio. Once again, here's the story as Tom tells it:

"In May of 1997, responding to calls for another list of ten great companies and in an effort to spotlight Rule Maker companies in a variety of industries, I pulled together a second portfolio... again promising not to trade out of the positions for ten years. Coming up with a name for it was tough, but I labeled it The Money-Heavy Portfolio (it sounded like a villain in a James Bond movie, so I stuck with it). Like Bond, the portfolio is winning, and winning with style."

Not as much style, mind you, as the Simpleton, but the Money-Heavy is well ahead of the S&P since its debut. Here are the results to-date:

        The Money-Heavy Portfolio

5/29/97 6/9/00 Purchase Present Total Company Price Price Gain Cisco Systems $7.42 $64.38 +768% Dell Computer $6.90 $45.06 +553% Gap Inc. $10.03 $33.06 +230% Intel $40.83 $127.06 +211% Microsoft $31.47 $68.81 +119% Johnson & John. $56.61 $86.13 +52% Pioneer Hi-Bred* $22.73 $27.58 +21% Coca-Cola $65.56 $52.31 -20% Gilette $42.37 $33.38 -21% Oxford Health $65.13 $21.56 -67% TOTAL N/A N/A +185% S&P 500 556 1457 +73% *Pioneer Hi-Bred was acquired by DuPont on 10/7/99 for 0.5643 DD shares per each share of PHB

Equal dollar amounts invested in each of these ten companies would've nearly tripled your money over the past three years. That's a 41.7% compound annual return, to be exact. By way of comparison, the Simpleton's annual return since 1995 is a jaw-dropping 74.4%. Except for the long shadow cast by the Simpleton, the Money-Heavy has been an incredible success, and I find it to be even more instructive than its higher-returning brethren.

Three lessons stand out in particular:

  1. Beating the market doesn't require perfection, just a few winners that you hold, hold, hold.

    The first thing that jumps out at me from the above table is that six of the ten companies -- more than half! -- have underperformed the market's average, and yet the portfolio as a whole has outperformed, and not by a small amount. How on earth? The answer happens to be one of the most important truths of investing in stocks: Your winners will pay down your losers many times over, provided you have the fortitude to hold, hold, hold your winner(s).

    But that's the hard part, isn't it? Because, as you probably know, this principle doesn't apply if you sell half of your winner every time it doubles. You don't have to be superhuman when it comes to picking stocks if you have the stomach to hold your winners. Try to let this lesson sink into your head, so your brain can explain it to your stomach the next time your favorite Rule Maker shoots skyward and you're tempted to "take some off the table."

  2. Sales growth is key.

    The Money-Heavy's biggest winners have shown strong growth in sales, while the losers have suffered mediocre top-line growth. Take a look:

    3-Year Annual
    Company            Sales Growth
    Cisco Systems 43.7% Dell Computer 48.2% Gap Inc. 30.1% Intel 12.1% Microsoft 29.7% Johnson & John. 8.3% Pioneer Hi-Bred* N/A Coca-Cola 2.0% Gilette 0.7% Oxford Health 10.9%

    As you can see, with few exceptions, strong sales growth is closely correlated to a rising stock price. Wall Street's Wise guys focus on earnings growth, but sales growth is where it's at. Why is this? Sales growth tells us there is growing demand for the company's products or services. In contrast, rising earnings may be the result of demand, but it may also just be the result of cost-cutting. Demand from customers is a much more powerful force than internal efficiency. Here in the Rule Maker port, we look for at least 10% annual sales growth, and the higher the better.

  3. Sector diversification is overrated.

    "... in an effort to spotlight Rule Maker companies in a variety of industries..." Hmmm, that turned out to not be such a great idea. Tom's attempt to diversify the Money-Heavy across multiple sectors rather than just focus on the best companies with the greatest market opportunities is the main reason for the plethora of losers. Diversification is one of the most overrated of all investment concepts. If you want diversification, stash a portion of your portfolio into S&P 500 SPDRs (AMEX: SPY). Otherwise, invest in the best companies you can find, regardless of which sector they come from.

Learning from past successes and mistakes is a great and very Foolish exercise. In fact, that's the whole point of our real-money portfolios, too. We expect to do some things right, some things wrong, but it's all instructive. That's why you shouldn't copy us. We're still learning, ourselves!

And if you want to join in on our next big learning exercise, consider signing up for our Rule Maker Seminar. (Click that link and notice you can enroll for free if you sign up for a BUYandHOLD.com account.)

Have a great night, and Fool On!

-Matt Richey, TMFVerve on the boards