Investing in Common Stock

A 'Total Quality' Portfolio Management Strategy

This paper is written and provided by SHARP INVESTMENTS, a Registered Investment Advisor. SHARP INVESTMENTS manages money for individuals and businesses. SHARP INVESTMENTS is a licensed and bonded investment company in Oregon and Washington. For a free consultation on the advantages of money management, contact Daniel R. Sharp at 503-520-5000.


Learn the big "secret" of investing

Learn the components of successful investing

Understand the skills needed to create wealth


The Secret of Successful Investing

Generally speaking, there are two schools of thought about investing in stocks.

The Chess Analogy - Investment returns are pure skill

The Bingo Analogy - Investment returns are pure luck

The truth lies somewhere in between. Investment returns are more like playing Bridge. In Bridge, the cards dealt are pure luck, but results are affected by the strategy of how the cards are played.

Investing, then, can be equated to a card game in which you receive cards randomly but win the game by playing the cards skillfully. Most people mistakenly think successful investing comes from picking hot stocks. Studies have shown that professionals, on average, are no better at picking stocks than throwing darts at the stock page of a newspaper. Think about it. There may be more than a hundred million individuals owning investments in this country alone. Why would you, your broker, relative, or neighbor have any better insight into picking a stock than the other 99,999,999 investors?

The next time you receive direct mail solicitations on investing, notice what is being advertised. The advertising doesn't tell you that if you follow proven portfolio management techniques you should have a greater number of winning investments than losing investments over time. No. What you get is how great Mr. So and So is at investing, the huge winners he has continually picked, and how for only $99.99 you can learn his secrets. I'm here to tell you, there are no secrets. If these investing opportunities are so great, why aren't the proponents putting their efforts into investing rather than attempting to separate you from your $99.99? Anyone can recommend a thousand stocks, and then crow about the 10 that did incredibly well.
Unfortunately, we all want to believe that someone has special analysis skills. This comes from the gambling mentality - we want to get in on a good thing. But when a Merrill Lynch with 1000 security analysts cannot pick stocks any better than a dartboard, it seems quite obvious that superior skills (for picking stocks) do not exist. Why are initial public offerings (IPO's) so hot? Because people feel they can't miss out on the good opportunity, even though 3 out of every 4 IPO made loses money for investors in the first 6 months. But still investors buy IPO's hoping to strike a one in a thousand opportunity like Microsoft or Starbucks. One in a thousand are not very good odds, or very smart investing.


This, then, is the most under-emphasized point in all of investing: Picking stocks is almost pure luck. Managing stocks is almost pure skill. So why would an investor want to spend so much more time picking the stocks, than properly managing the stocks?


The secret: An investor makes money from playing the cards, not from picking the cards.


Picking the cards - Security Analysis


Security Analysis is the process of studying all available public information on a stock, and trying to determine if it is priced below it's true value. It is a time consuming, extremely competitive process. There are literally hundreds of thousands of professional analysts and millions of amateur investors following and analyzing all publicly available information. This is why picking winning stocks is so difficult. Everyone else is competing to find undervalued stocks and, in the process, most stocks are priced extremely close to their true market value.

While stock selection is almost a completely random process, there are some general rules that have worked well in the past. If an investor were to pick stocks almost randomly but followed these rules, they would have done very well:

1. Historically, almost half of the return of the stock market has come from dividends

2. Historically, stocks perceived to be undervalued rather than growth opportunities have produced better returns over long periods of time with less risk. Academians attribute this to investor overreaction. This is where popular (usually growth) securities are priced slightly higher than they deserve, and unpopular (value) securities are priced slightly lower than they deserve. In time the situation corrects, as popularity is usually temporary. Growth securities move down and value securities move up. As Benjamin Graham, the father of value investing once said, "The stock market is a voting machine in the short run, but a weighing machine in the long run".

3. Recent studies have shown smaller undervalued stocks to have greatly outperformed the market over the last 10 years. This again, is attributed to an even stronger investor overreaction because smaller stocks are followed by fewer investors.


Selecting from the pool that has proven to be the most successful in the past (smaller undervalued companies) is no guarantee of success. The investor still must separate the truly undervalued securities from those that actually deserve their low pricing. This is the objective of fundamental security analysis (market, industry and company).

However, studies have shown that returns are much more dependent on portfolio management styles than the selection of the securities. Supporting this is a recent study by William Sharpe, Nobel prize winner. Management is much more important than selection of securities, but many investors spend very little time managing their portfolio. Most effort spent on picking the stocks to buy is a waste of time.


The following is an investment management strategy based on history, facts, and common sense. Putting together an efficient management process is known as Total Quality Management (TQM) in manufacturing companies. TQM is now starting to be used in the service industry, and provides a clear advantage over the competition, much as it has done in the manufacturing industry. The concept of TQM involves the continual improvement of a process, which in this case means refining and improving the odds of investing success.


Playing the cards - Total Quality Portfolio Management


There are a number of portfolio strategies available, that if followed, will each add a small amount of extra investment return to the portfolio, and collectively, produce superior returns in the long run.

8 Point TQM Portfolio Management Strategy

1. Diversification
2. Long Investment Periods
3. Dividend Strategy
4. Dollar Cost Averaging
5. Limit Orders
6. Portfolio Loss Control
7. Long Term Market Timing
8. Patience and Discipline



1. Diversification


Proper levels of diversification can be used to minimize risk while still allowing appreciating securities to dominate a portfolio. Diversification can eliminate non-market risk from a portfolio, that is, risk associated with owning a particular company. Diversification is not the same as the number of investments held in a portfolio. Diversification is minimizing the correlation between each investment held in a portfolio. This is usually accomplished in a stock portfolio by holding stocks of differing industries.

What is proper diversification, as opposed to over or under diversification?
The graph below shows the maximum reduction in portfolio risk for each security added to a portfolio. As can be seen, the level of risk is reduced from 50% to 20.3% with as little as ten properly diversified securities. Adding another 1000 securities to the portfolio would reduce the risk to 20.1%. The first ten securities in a portfolio diversifies away over 97% of the non-market risk. Diversification, or elimination of the non-market risk, can lower the risk of a common stock portfolio to 20%, which is the level of market risk that every portfolio holds. Market risk, the risk associated with the stock market in general, can never be eliminated or reduced.



Over diversification produces market results minus expenses
Many mutual funds hold close to a thousand securities in their portfolio, which reduces non-market risk a small fraction more than a portfolio of 10 securities. But the question must be raised as to whether the costs of holding a thousand securities are worth the small reduction in risk. The personnel, equipment, and administrative costs associated with analyzing, following and holding large numbers of securities are passed on to the mutual fund investor. And for what? Basically, for attaining the same returns as the market in general minus the extra expenses mentioned.

Under-diversification produces large amounts of unnecessary non-market risk
Holding five or fewer securities allows for a high level of non-market risk in a portfolio and is generally not recommended. An example of an exception to this rule are company founders and officers that hold vast amounts of a single security. They can afford the high levels of non-market risk because of their wealth. I doubt that Bill Gates of Microsoft loses much sleep dependent on whether he is worth 10 or 11 billion on any particular day.

Most industry specific mutual funds are quite under-diversified in spite of the high numbers of securities owned by each mutual fund. Each security in an industry specific mutual fund is quite susceptible to common industry factors which creates a high level of non-market risk, even if the fund has close to 1000 companies represented.

Therefore it makes little sense for the investor to pay the high management fees of an industry specific fund, because in order to be properly diversified the investor must pick nine other industry funds from other industries.

Why not save on the fees and pick 10 stocks instead of 10 mutual funds?


2. Long Investment Periods

Long-term investing can be used to minimize transaction costs and maximize the compounding effect over time.

The stock market is a 50/50 gamble in the short run (a random walk). However, in the long run the results are biased in the favor of the investor. Stocks can never be worth less than zero, but have no such limitation on the upward side. This is because of the limited liability feature of owning corporate equity. Investors are never liable for debts of the company beyond their initial investment in common stock. This means that a stock is as likely to double (up 100%) as to go to 50% of value (down 50%), as likely to quadruple (up 300%) as to go to 25% of value (down 75%). The reason for this is due to the infinite maturity of common stock, mentioned earlier. Therefore the longer a investment is held, the better the odds become that this investment will do well.


3. Dividend Strategy

In theory, companies that defer payment of dividends to investors in order to reinvest all earnings compensate investors through appreciation of their ownership (capital gains).

In practice, over the last 100 years, companies that pay dividends have had the same or greater capital appreciation as those that defer dividends.

Dividend reinvestment plans increase portfolio returns. Many companies allow investors to buy securities directly from them at a significant discount with no commission on reinvested dividends and discounted prices on reinvested funds. Since historically almost half of all portfolio returns are from dividends, investors using dividend reinvestment plans pay zero commission on half their gains. Some discount brokers offer commission-free dividend reinvestment on all securities.
Dividend reinvestment plans also provide a method of purchasing stock on a regular basis. Investing equal amounts of cash each quarter (the reinvested dividend) allows more shares to be purchased when the security is undervalued, and less when it is overvalued. This is known as dollar cost averaging.


4. Dollar Cost Averaging

Dollar cost averaging is a buying strategy that involves putting a set amount of money into the market every week or month. This gives the investor more shares when the market price is low and less when the market price is high. This strategy takes advantage of the random nature of the market, buying less shares in overvalued markets and more in undervalued markets. This strategy also allows an investor to slowly establish a position in a security while continuously evaluating the opportunity. Usually 5 or 6 equal purchases can be spread over a 3 to 6 month period. If the security experiences a problem before the purchases are completed, the investor doesn't experience the same loss as if they plopped down the entire amount in a single purchase.


5. Limit Orders

Limit orders can be used to buy securities at significant discounts to market prices. Limit orders are orders to buy a security only if it reaches a specified price. A properly set combination of limit orders set below the market price can add significantly to portfolio returns. It should be noted that limit orders involve making a low bid on a security, which doesn't guarantee the purchase of the security as a market order would. But the limit order can be set with a high probability of making the purchase at a discounted price.

Since security prices in the short run are almost completely random, it is a simple process to set a limit order below the market price and purchase the security at "wholesale" prices rather than "retail" prices.

Sophisticated investors can calculate the probability of a security randomly moving down to a certain price in a certain number of days. They then can set a limit order knowing the odds of purchasing the security.

True bargain hunters can even calculate and set simultaneous limit orders on several securities with the idea of picking up one of these limit orders at a deep discount.


6. Value Investing

Value Investing is the art of selecting securities that are selling for less than their intrinsic economic value. Value stocks are frequently unpopular, out of favor companies with some sort of perceived problem that makes them repulsive to most investors. Conversely, growth stocks are popular, high growth stocks that are priced at a premium and have usually performed well recently.

As a human, are you attracted to something with a bright future, exciting prospects, a good story, and something most others covet also? Or are you attracted to something with an uncertain future, boring prospects, not much of a story, and something no one else wants? Of course you, like millions of other investors, are attracted to the former. However, successful investing almost always demands you do the opposite of your basic human nature.

Have you ever been to an auction? People that bid on unwanted, unloved items often are the only bidders and consequently may pick up a bargain. However, items that get a lot of attention and bidders often sell for an inflated value in a frenzy of competitive bidding. Stocks work exactly the same way. Stocks that are popular, glamorous, and have great prospects are widely followed and purchased, garner lots of attention, and are attractive to the vast majority of investors, who love consensus. Stocks that are unpopular, boring and have poor prospects are neglected, get little attention, and are repulsive and uninteresting to the majority of investors.

Therefore, growth stocks have very high expectations and value stocks have very low expectations. Is it easier to exceed high expectations or low expectations?

Studies show that investors tend to overweight recent events in regard to forecasting future growth rates of investments. Companies that have had a large recent amount of good news tend to sell at a bit of a premium to the true value, and companies that have had a large recent amount of bad news tend to sell at a bigger discount than they should.

Investors flock to the popular securities, keeping the price a little higher than warranted, and avoid the unpopular, which lowers temporary demand and the market price below where it should be. Almost all of the growth companies will eventually fail to meet the ever increasing high expectations and start the move towards becoming a value company. Investors think every growth company is the next Microsoft, but they are the rare exception. The rule is eventual disappointment. Conversely, most of the value companies eventually will exceed the low expectations and begin the transition back to a growth company. Some will go bankrupt or never exceed the low expectations, but again, this is the exception. While popularity can change overnight, unpopularity usually takes a good part of a market cycle to reverse itself. Buying a value stock means possibly having to wait for several years in order to see the reversal. The reward? Value stocks have returned 18% over the last 60 years, compared to 10% for the market in general and 7% for growth.

The morale: A great company is not always a great investment, and a poor company is not always a poor investment. Too many investors fail to recognize this.


7. Long Term Market Timing

Proprietary econometric models can be used to indicate what helped contribute to winning investments in the past under various market and economic conditions. Trying to predict anything in the market short term is almost impossible, but there are some repeated historical long term trends that can be applied in various situations.

1. Certain indicators have historically indicated an over or undervalued market, the most reliable being dividend yield, price to earnings ratios, and interest rate level.

2. Different groups of securities benefit or suffer from certain phases of the economic cycle, and portfolios can take this into account when determining asset allocation mix. Examples of this are defensive stocks, cyclical stocks, and counter-cyclical stocks.

3. There are academic studies indicating that certain derivatives are extremely sensitive to overvalued markets and may serve as a predictive signal of market changes.


8. Patience and Discipline

The gambling "get rich quick" mentality must be suppressed. There is no free lunch, no such thing as a risk free money making investment. The essence of gambling is taking on risk for risk's sake, i.e. taking on risk when the odds are stacked against winning. On the other hand, true investing means only taking on risk when the odds are stacked in favor of winning.

The second guessing of rules and methods leads to disaster. As George Bush liked to say; stay the course! Making an exception to a disciplined investment plan can set an investor back years in meeting a goal. Opportunities that seem too good to be true - almost always are.

Investors must block out the urge to listen to experts, brokers, and anyone who's opinion isn't based in fact. With millions and millions of "experts" freely offering their opinions, an investor can find support and explanation for buying, holding, or selling every investment in the world. Anyone who professes to be able to predict "sure things" is suspect. Investing is a matter of probabilities and long term outcomes. More credibility should be granted to those who admit they can't predict short term than to those sure that a certain event will unfold in a certain manner.

Sometimes investors must go against the crowd to make money. It can be very lonely, but very lucrative, to go against the current thinking of the day. Historical perspective often proves much more valuable than the current consensus. Popular opinion often assumes the most dangerous five words in investing; "Things are different this time".








This eight point Quality Control Portfolio Management plan does not guarantee success, but it does make success more likely. Stacking the odds in the investor's favor is a common sense approach to the long term creation of wealth.

The technique works equally well to your individual retirement funds, investment portfolio, or a business retirement plan. It has worked for the last 400 years, and I am confident it will continue to work well in the future.

Many individuals and some money managers have figured out the keys to success, spelled out in the eight point plan. Most still spend large amounts of time trying to "pick" a successful stock, rather than spending their time more productively managing their portfolio.

Portfolio management is not for everyone, some lack the aptitude, most lack the time and tools. If your funds are being managed by a "stock picker" rather than a portfolio manager perhaps it is time to consider the common sense approach used by Sharp Investments.


Conclusions

o Investment returns are a combination of luck and skill

o Picking the stock is almost pure luck

o Managing the portfolio is almost pure skill

o Investors should spend more time on management, and less time on picking the stocks

o Without the right investing attitude, chances of success are slim

o There are strategies designed to increase the odds of investment success, tested and proven by time

o The combination and improvement of these strategies can be referred to as Total Quality Portfolio Management

o Sharp Investments practices Total Quality Portfolio Management to increase the odds of long-term investment success