To reach your goals, focus on absolute, not relative, returns.
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By Mark A. Sellers | 01-28-04 | 06:00 AM | Email Article

In a prior column, I made a case for stocks being a better relative value than bonds. I did this by converting nominal yields into real yields to show the expected increase (or decrease) in purchasing power over time among stocks, bonds, and cash. My conclusion: Neither bonds nor stocks will probably do very well over the coming decade because the yields on all three are starting from too low a level. Historically, 10-year stock and bond returns have been pretty bad when starting from a point in time when earnings yields and interest rates are very low.

This presents a big problem for people who need higher returns to reach their long-term financial goals. I'd argue that this includes just about everyone except those who are in "preservation" mode with their assets (retirees or those close to it). For those of us with a fairly long time horizon, the relative performance of bonds versus stocks isn't what matters. All that matters is an increase in purchasing power by the time we need to cash in our chips.

So, what can you do to solve this low-yield dilemma?

The Fat-Pitch Approach
The solution to the low-yield dilemma is this: The "fat-pitch" approach to stock investing. This strategy can best be explained using a baseball analogy.

In baseball, a batter who watches three pitches go past just inside the strike zone will be called out by the umpire. Thus, baseball players often have to swing at pitches they would rather not. Many investors, especially professionals, are playing baseball when they invest. They fear being "called out," so they swing at pitches that they would rather watch go by. In other words, they forget their valuation discipline and think about investing like it's a baseball game--three called strikes and you're out.

But what if the rules were different? What if a player could watch any number of pitches go by, waiting for the perfect "fat pitch" to come along before swinging? Baseball will never adopt this rule, of course--games would last too long and players would routinely break Hugh Duffy's 1894 single-season batting average record. But you, as an investor, can (and should) play by these rules--no one can stop you from doing it.

This strategy has five parts:

1. Look for wide-moat companies. 
Companies with wide economic moats, such as  Expeditor's International ,  Kinder Morgan  ,  Iron Mountain , and  Stericycle , among others, reside in profitable industries and have long-term structural advantages versus competitors. They're "fat pitches" with predictable earnings and long-term staying power. The odds are pretty high that over time, these companies will create shareholder value. By contrast, companies with no economic moat generally destroy shareholder value over time--when you buy one of them, you're making a speculative bet that the stock will bounce up just long enough for you to sell it. That's a very tough game to play, and only seasoned pros should attempt it.

2. Always have a margin of safety.
Here's where you'll need to exercise a lot of discipline and wrestle with your fear of missing out on a rally. Instead of buying a stock based on what everyone else is doing, buy a stock only when it's selling at a decent margin of safety to your estimate of its fair value. Don't even think about the overall direction of the stock market, because that's impossible to predict with any consistency. Think only about individual wide-moat companies; if you find one where the price is irrationally low relative to its long-term intrinsic value, consider buying it. If not, hold off.

3. Don't be afraid to hold cash.
Holding cash is like holding an option--the option to take advantage of volatility. The value of this option rises when market volatility rises. Many market participants neglect this important aspect of investing and stay fully invested at all times. When the market drops, they can't do anything but watch (or sell out near the bottom). Being fully invested goes hand-in-hand with a focus on relative returns. Remember, we care only about absolute returns, not relative returns.

4. Don't be afraid to make big bets.
There are very few good ideas in any given year--Warren Buffett has said he's happy to have even one. For the rest of us (i.e., those without the need to invest $1 billion to make a difference in their portfolios), there may be five or six good ideas a year. In any event, if you feel the need to hold more than 20 stocks, you aren't using the fat-pitch approach--you're speculating and trying to diversify away the risk by holding lots of different names.

Of course, it's risky to hold a concentrated portfolio unless you do three things:

1. Only buy wide-moat companies
2. Only buy them at a significant discount to fair value
3. Have a time horizon of at least 3 years on each pick you make

If you aren’t willing to follow these three rules on each and every stock you buy, then you need more diversification in your portfolio.

5. Don't trade very often.
If you're using the fat-pitch approach, you won't need to trade very often because you'll hold only wide-moat companies. We rate these companies wide-moat because they have long-term advantages and create shareholder value year-in and year-out. Because they create value each year, their fair values tend to rise over time. These are the only types of stocks in which a buy and hold strategy works well. As I said earlier, when you buy a no-moat stock, you are making a bet that it will bounce up just long enough for you to sell it.

Think of it this way: Investing is nothing more than a game of probabilities. No matter how diligent you are, your fair value estimate for a stock will never be exactly right. In essence, fair values are just an estimate of what a stock is worth under the most likely scenario for future earnings growth and profitability. Thus, there's always less than a 100% probability that you'll be right about a stock pick. Given that the odds are below 100%, there's little point in trading from one stock to another frequently; your odds of being "right" on the new pick are probably only a little higher than the odds of being wrong on the current pick.

Add to this the costs of trading--including taxes, bid-ask spreads, and commissions--and the odds of generating higher returns by trading frequently are worse than simply buying great stocks at good prices and holding them for three years or more.  

Tortoise and Hare Portfolios
We use the fat-pitch strategy to manage the Tortoise and Hare Portfolios for Morningstar. These portfolios, funded with Morningstar's own money, each consist of 10 to 15 of our favorite wide-moat stocks. So far, the fat-pitch strategy is working like a charm. Since June 2001 when we rolled them out in Morningstar StockInvestor, the Tortoise is up 40.7%, the Hare is up 2.2%, while the S&P 500 is down 4.4%. Taken together as one portfolio, the combined Tortoise and Hare are up 21.6% over the past 2.5 years. And with a beta of 0.88, the portfolios have been 12% less volatile than the overall stock market.

Full details on the performance of the Tortoise and Hare appear in the January 2004 issue of Morningstar StockInvestor.

A version of this article appeared June 18, 2003.

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Mark A. Sellers does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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