Ten Part Guide to Beating the Market

By Joshua Kennon

1 Simple Steps to Help Anyone Beat the Market

In the first part of this series, I wrote a 10 Step Guide to Building a Complete Portfolio. It shows you how to put together the basic financial picture individuals should have to help them become successful and wealthy; from emergency cash reserves and buying a home to 401k, brokerage, and education accounts. Then, I wrote a related Eight Secrets to Improving Your Portfolio Returns. In this related step-by-step, I go into the specific behaviors that tend to produce above-average results once you have established your foundation. Many of these steps will lead you to more in-depth articles that I’ve written over the years if you find you need or want more information about a particular topic.

Make yourself comfortable, kick up your feet, and stay awhile. From my office to your home, here are ten things that can help you experience fatter profits on your long-term investments.

2 Keep Turnover Low and Minimize Frictional Expense

This one’s not new; the evils of turnover (buying and selling investments frequently), have been well documented. In fact, I mention it in Eight Secrets to Improving Your Portfolio Returns. It’s important enough, however, to repeat. Many investors don’t have a clue what a market maker’s spread is, nor do they understand that just holding the assets they already own can result in much higher long-term returns. But those expenses, dubbed “frictional” by Warren Buffett, including commissions, capital gains taxes, spreads, and management fees, can eat up a huge percentage of your total return.

Don’t believe it? Consider that the long-term return on equities is roughly 11%. Imagine that two fictional investors, Sarah and John, each is 25 years old and want to invest $10,000 per year until they retire at 65. Sarah focuses on buying high-quality blue chip stocks with fat dividends and established businesses, parking the stock certificates in a safety deposit box and forgetting about them. John, on the other hand, frequently trades and racks up an additional 3% per year in frictional expenses, some of which are invisible to him (you, for example, don’t really realize you are paying a mutual fund manager or a market maker but the costs to you are very real.) Over the next 40 years, Sarah will retire with over $5.8 million. John, on the other hand, despite investing the same amount of money and working much harder, frequently turning over his portfolio, will only have $2.6 million as a result of his lower 8% compounding rate (11% - 3% in frictional expenses = 8% compounding annually.)

For more information on specific frictional expenses you can avoid, read Frictional Expenses: The Hidden Investment Tax.

3 Use the Tax Law to Your Advantage

Did you know that the exact same investment could compound at very different rates depending upon the account through which you own your stake? In the article Tax Strategy: Asset Placement, you learned how placing certain bonds and dividend paying stocks in a tax-advantaged account, such as a 401k or IRA, could save you thousands of dollars per year, not to mention the value it would add in terms of compounding tax-deferred for several decades.

Another common mistake is when investors focus on the immediate tax savings of contributing to a Traditional IRA, SEP-IRA, or similar vehicle. I’ve heard many hardworking, honest people say to me, “Oh, my accountant said that because I’m in the 25% bracket, it would save me only $1,000 and the money would be locked up for decades.” The tragedy is that the real savings include not only that $1,000 which will now compound for you instead of going to the government, but also, the fact that these accounts allow you to plow back your profits into more investments, tax-free, until they are withdrawn. That can mean literally hundreds of thousands or millions of dollars more working for you.

Additionally, investors who are in the top tax brackets will almost always, without exception, buy tax-free municipal bonds. This makes sense as they can actually make more money on a tax-free yield of 4.5% than a taxable yield of 6.5% (to learn how to calculate the taxable equivalent yield yourself, take five seconds and check out Investing in Municipal Bonds.) The flip side of this is that if you own bonds through a tax-advantaged fund, it is foolish to buy these sorts of issues as they usually have lower yields to compensate for their favored status. In a tax-advantaged account, this obviously has no value. You’d be better off going with a fully taxable corporate bond base widely diversified among issuers.

4 Commit to a Value Investing Philosophy

If you want to be successful, it is probably a good idea to study those people and companies that have already achieved that success. In the stock market, it should be fairly obvious to an outside observer that the best returns over long periods of time are typically racked up by value investors that focus on buying assets for less than their true value such as Marty Whitman, Warren Buffett, Charlie Munger, Peter Lynch (despite owning some growth names, his positions were always based upon a relationship to the company’s earnings or assets), Eddie Lampert, Wally Weitz, and a host of other folks who are focused on the relationships such as the multiple of book value to market price, discounted earnings, multiples to cash flow, or owner earnings, price-to-earnings ratios, and other factors, many of which were first preached by legendary author, professor, and money manager Benjamin Graham.

In practical terms, this means that when you buy a stock, you should know exactly the growth rate required in the underlying earnings for it to meet your expectations. It is insufficient to say, “I bought shares of McDonald’s because I believe in ten years, they will be worth 400% more than I paid for them.” Instead, you should say, “Based upon the company’s currently low p/e ratio, improved earnings, plan to sell of locations in Latin America, and cash dividend and share repurchase programs, I think that 15% growth per annum, on average, is very likely over the next ten years. The result is a total pre-tax gain of 400% on an investment today.” The difference between the first and second statements is night and day; throwing a dart toward the stock tables versus making an informed, analytical decision based upon underlying fundamentals.

I’ve put together an entire Value Investing category filled with articles and resources to help you get started.

5 Avoid Wipeout Risk at All Costs

In order to compound your wealth, you must have something to compound. Sounds pretty simple, right? Well, you might be surprised how often people, who otherwise work very hard for their money and are responsible enough to shop for the best prices on refrigerators, washers, dryers, appliances, and their house, are willing to hurl cash at a company they believe has even a minor chance of success.

What is really going on in this situation is a form of the psychological concept of social proof. Much like the popular clique in high school, a large percentage of the population has a fundamental need to feel like they are part of a group. From an investing standpoint, this can be fatal. Some general (although necessarily flawed) ways to tell if there is wipeout risk:

The company sells or sold products that have enormous potential liabilities such as asbestos

The price-to-earnings ratio is over 40 or 50

The debt-to-equity ratio is astronomically high (for one notable exception caused by share repurchases, read the article Looking Past the Numbers – The Limitation of the Debt to Equity Ratio.)

Never invest in something you don’t understand. A good test is your ability to write out, in one short paragraph, how the company makes its money, the sources of its profits, its most important customers, the competitive landscape of the industry in which is competes, the honesty and competency of management, and your expectation for company earnings in the next five to ten years.

Although profitable, the cash flow is barely exceeding fixed expenses such as operating leases. It has happened in the past that otherwise good companies have been forced into bankruptcy because they couldn’t make their lease payments; the debt for which does not show up on the balance sheet but is instead buried in the financial statements.

6 To Beat the Market, View It as a Stock

In the article by the same name, To Beat the Market, View It as a Stock, I showed you how to view your portfolio as a single equity and the stock market index of your choice the same way. You could then compare the earnings, debt levels, growth rate, returns on equity, sector compositions, etc. of each “stock”. If, for example, your portfolio has a lower growth rate and a higher price-to-earnings ratio than the market, the odds of you generating good investment returns are very, very slim short of a speculative bubble or if you are investing in an industry in which you have specialized knowledge and you expect a turnaround shortly.

One of the best tools available for doing this with little or no effort is the Morningstar X-Ray program. To access it, you can either pay for a premium subscription to the Morningstar web site, giving you access to countless analyst reports on companies and mutual funds, or you may be able to get it through your stock broker (E-Trade Financial, for example, offers it for all of its brokerage clients.)

7 Pay Yourself First

This staple of personal financial advice is the cornerstone of success. The basic premise is this: When investing for your future, setup automatic withdrawals from your paycheck or bank accounts. Just like your utility bill or car payment, the money will be taken out before you really have access to it. In the meantime, it begins to compound and you don’t miss the money. (As humans, we are remarkably adaptable. If you don’t have the cash, you’ll find a way to get by. Sure, you may own fewer pairs of shoes or a couple fewer season subscriptions on iTunes, but you’ll make due and after awhile, likely not notice.)

This strategy has been key to the success of some of my closest friends and family members. One person in particular with whom I am close literally worked full time and had no mattress or groceries, yet now has investment capital that, adjusted for her age, will result in substantial wealth given enough time parked in decent assets. It may be difficult in the short-term, but long-term it’s worth it.

For more information, read Pay Yourself First: One of the Most Effective Strategies for Attaining Your Dreams and Goals.

8 Know When to Throw in the Towel and Buy an Index Fund

Statistically, most people are doomed to compound their capital at a rate lower than the market as a result of frictional costs, and even more expensive, emotional losses caused by gut reactions such as selling in a crashing market or buying during a bubble. In this case, the timeless advice “Know thyself” is worth its weight in gold.

That’s why I wrote If You Can’t Beat ‘Em – Join ‘Em: Investing in Low-Cost Index Funds. The basic gist of the matter is that index funds, which can mirror any one of the major stock market indices, have a far lower cost structure than traditional portfolios; a typical index fund, for example, might charge 0.15% versus 1.25% for a regular, run-of-the-mill mutual fund. In addition, the index only sells stocks when they are dropped as a result of mergers, de-listing, or admitting a better company. This results in lower turnover, which was one of our earlier secrets to beating the market.

In short, if you are looking for a no-brain way to own America, Inc., an index fund is probably the way to go.

9 In Investing, Smaller is Normally Better

Generally speaking, it’s better to invest in small and medium size companies than large businesses. The reason is simple: It is ordinarily far easier to grow earnings at 15%+ on a small base of, say, $50 million than it would be on a base of $10 billion. Wal-Mart has pointed out that in order for it to grow at an even remotely acceptable rate, it has to add sales that would, by themselves, create a Fortune 500 company.

There are exceptions, and although rare, it looks like we are experiencing one at the time this article was written. Companies such as Home Depot, Johnson & Johnson, Berkshire Hathaway, Target, Wal-Mart, Wells Fargo, etc., are all trading at prices that, relative to most of the smaller equities, makes them much more attractive. How long can this situation be sustained? No one has a clue. The result has been an interesting skewing of many value investor portfolios toward larger companies. Although these businesses haven’t moved for quite some time, owners can wait patiently as they receive their dividend checks.

10 Know What Risk You Are Trying to Avoid

Imagine the following scenario: You have $100,000 in capital. You decide to invest $20,000 of it in a bank that is trading at only 10x earnings with a 4.5% cash dividend yield in a world of 2.5% inflation and the company looks to have great growth potential with a healthy mix of fee and interest income. The next day, the markets crash and your position loses 20% of its value. How do you feel?

The answer should be easy: Ecstatic. Many investors, academics, and market pundits confuse real risk (such as liquidity risk, bankruptcy risk, permanent capital impairment risk, etc.) with volatility. Unless you need to sell quickly (in which case you should not have owned stocks at all!), lower prices means nothing more than the opportunity to augment your holdings in some of your favorite companies at attractive earnings yields.

For a more in-depth discussion, read The 3 Types of Investment Risks and Risk Management: 6 Warning Signs That a Company May Be Headed for Trouble.