How to Outperform the Market

How to Outperform the Market (eBook Cover)Updated on January 10, 2014: the eBook version is available here.

“Investment is most intelligent when it is most businesslike.” -Benjamin Graham

The investment strategy that we follow to outperform the Stock Market is very simple: invest in a portfolio of great companies for the long-term and sell when they are no longer great companies or if there are better investment opportunities.

Many people believe that they have to constantly watch the Stock Market and trade stocks in order to outperform it. But we believe that stock trading involves a lot of speculation and is not the best way of investing. We believe that the best way to invest in stocks is to have a business mindset—instead of a Stock Trader mindset—and to invest as though you are acquiring the entire business.

Benjamin Graham—the father of value investing—taught his students to invest with a business mindset and with a great margin of safety. Warren Buffett—the greatest investor of our time—was one of Graham’s students. He adopted Graham’s investment approach and successfully outperformed the U.S. Stock Market by a large margin for over 40 years. Between 1965 and 2012, his investment holding company—Berkshire Hathaway—achieved a compounded annual return of 19.7% vs. the S&P 500′s 9.4%. This means that if you invested $1,000 in his company in 1965 and held the stocks until 2012, your investment would have become approximately $5.87 Million (see below image). If you made the same investment in the S&P 500 index, your investment would have become approximately $74,330. This is why we believe that long-term investing is better than short-term investing and investing with a business mindset is better than a Stock Trader mindset.

Berkshire Hathaway vs the S&P 500

Source from Warren Buffett’s 2012 Annual Shareholder Letter: http://www.berkshirehathaway.com

Intelligent Investor vs. Stock Trader Mindset

“Be fearful when others are greedy and greedy when others are fearful.” -Warren Buffet

A Stock Trader invests in stocks for a short period of time and makes trades based on the latest market headlines, economic data, trends, volume, stock momentum, technical charts and human emotion. The Intelligent Investor—with a business mindset—focuses on company fundamentals and buys stocks when they are undervalued or fairly-valued, ignores market noises (e.g. headlines or rumors)­ that do not affect the companies’ fundamentals, and patiently allows the stocks to grow.

To have a business mindset as suggested by Benjamin Graham, you must follow these principles:

First, you must see owning stocks as partial ownership of real companies instead of as stocks tickers that are traded in the stock market. This means that you must see yourself as a partial owner of the companies that you invest in.

Second, you must invest for the long-term instead of the short-term. The reason is that stocks can be very irrational and unpredictable in the short-term as they are mainly driven by market sentiment and the latest headlines. Stocks are more predictable in the long-term because they tend to increase or fall to reflect the companies’ fundamentals or intrinsic values. For example, if a company’s stock drops 10% in one year due to negative news and becomes undervalued, its stock will eventually recover to reflect the company’s long-term business prospects and its intrinsic value.

Those who allow the latest headlines to determine their investment decisions will likely follow the market and buy stocks when everyone is buying and sell stocks when everyone is selling. This is not the best way to invest in stocks because the stock market is not always efficient. And it is often overly optimistic or pessimistic.

Third, you must be forward-looking instead of backward-looking when you analyze stocks. In the business world, it is always easier for people to analyze stocks using their past performance to project into the future. Many investors also make this mistake. Warren Buffett once stated, “The investor of today does not benefit from yesterday’s growth.” If you want to determine the stocks’ future growth potential, you must focus on their business fundamentals and their future business prospects. Stocks usually increase in the long-term if the underlying company continues to have better business prospects, higher revenues, net income and free cash flow.

Fourth, you must invest in stocks that you understand the most and stay away from stocks that are speculative. Before you decide to invest in a company, you should be able to answer yourself, “Why am I investing in this company?”

Finally, you must invest in stocks that you are willing to hold for a long time and that you are willing to invest a large amount of capital in. This will force you to only invest in companies that you understand the most and companies that have good prospects with the least amount of risk.

How to Pick Great Stocks

“Invest in what you know.” -Peter Lynch

There are many ways to pick great stocks. An intelligent way to pick great stocks is to look for great businesses around you that you believe will perform well in the long run.

Peter Lynch, the famous fund manager who outperformed the market for thirteen years, coined his investment principle as “invest in what you know.”

This principle can help investors outperform the market because our local knowledge can help us identify great businesses around us without being professional investors, analysts or portfolio managers. Moreover, our local knowledge often reveals things (e.g. a company’s business prospects) ahead of time and more accurately than the analysts that we often hear about on the news.

When you look for great businesses around you, you will want to ask yourself these questions:

  1. Does the company make great products and services that are popular among consumers?
  2. Is the company continuously making better products and services?
  3. Is the company innovative?
  4. Is the company a leader in its industry?
  5. Does the company have great competitive advantages?
  6. Does the company have a great business model?
  7. Is the company’s business hard to replicate?
  8. Does the company have great leaders and management?
  9. Is the management team shareholder friendly?
  10. Does the company have great business prospects?
  11. Does the company have a lot of growth potential with increasing earnings?
  12. Does the company generate a lot of operating income and free cash flow?
  13. Doe the company have a healthy and strong balance sheet?
  14. Will the company be around for at least 10-20 years?
  15. Would you be willing to invest a large amount of your net worth in the company for the long-term?
  16. If the stock plunges for various reasons (e.g. a recession), would you hold or sell the stock?
  17. If you invested in the stock, would you consider yourself to be a partial owner of the company?

If the answer is “yes” for most of the questions above, then you have likely found a great company to invest in for the long-term! You can use this process to find many great companies around you. We used the same process and found many great companies, including Google and Disney, that have outperformed the market since we recommended them. (Click here to learn more about our Premium Service that provides members with access to our monthly stock picks that we believe will outperform the market.)

How to Create a Great Stock Portfolio

“If a business does well, the stock eventually follows.” -Warren Buffet

After you have identified a list of great companies that you want to invest in, there are many ways to build a great stock portfolio. One way is to invest in stocks on a monthly basis. This is similar to dollar-cost averaging. It is a good way to build your stock portfolio if you do not want to time the market or if you want to avoid the risk of investing a large amount of capital in stocks at the wrong time. Another way is to time the market and try to buy stocks at the lowest price possible. This requires one to analyze stocks, estimate their intrinsic values, follow the market and be patient enough to buy them when they are undervalued. Since the second method requires a lot more time, we would suggest most investors to invest in stocks on a monthly basis and invest a fixed amount of capital each month. One can invest in different stocks each month to diversify risk.

For example, you can invest in one great stock each month. You can start by investing $3,000 every month in different stocks to build a portfolio of more than 20 great stocks. You can invest in the same stocks in different months if you understand them and are comfortable with their risk and growth. We do not suggest buying a stock all at once unless you understand the company’s business, as well as its growth prospects, value and potential risk. This is because a stock can be overvalued at any given time. In addition, we suggest selling your stocks only when you can find better opportunities to reinvest your capital or when the stocks you hold are no longer great companies. We do not recommend selling your stocks for short-term gain (unless you need the money) because great stocks tend to increase significantly more in the long-term.

If you pick great stocks by “investing in what you know” and investing with a business mindset instead of a Stock Trader mindset, then you will very likely outperform the market in the long-term. When you invest with a business mindset, you will also have no problem going through the emotional ups and downs of the market. This is because the market can be irrational at times. The market can cause investors to make irrational decisions when it is overly optimistic or pessimistic. This was demonstrated during the dot-com bubble (1997 to 2000) when many investors followed the market’s euphoria and invested in internet stocks that were exceedingly overvalued that made little or no profits. The dot-com bubble burst on March 10, 2000 and the Nasdaq Composite plunged 74% in the next two years. This reminds us of the importance of investing in what we know and staying away from stocks that are over-hyped by the market.

Summary

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” -Warren Buffet

In summary, to create a great portfolio that can outperform the market, you can follow the following six steps:

Step 1: Have a business mindset instead of a stock trader mindset.

  • See stocks as partial ownership of companies and not as stock tickers for trading purposes only.

Step 2: Look for great companies around you that you understand the most.

  • Invest in what you know and stay away from stocks that are speculative.

Step 3: Start building your stock portfolio by investing in one or two great stocks each month.

  • Invest a fixed amount of money in different stocks each month until you build a portfolio of more than 20 great stocks. Invest in the same stocks in different months if you understand them and if you are comfortable with their risk and potential returns.

Step 4: Invest for the long-term instead of the short-term.

  • We suggest investing for the long-term because the risk is lower and great stocks tend to increase much more in the long term than the short-term.

Step 5: Continue saving and investing every month.

  • Save a portion of your income every month, so you can build your portfolio and invest in great stocks for the long-term.

Step 6: Sell your stocks when you can find better investment opportunities or when the stocks you invest in are no longer great companies.

  • We suggest selling your stocks only in these two scenarios (unless you need the money) because great stocks tend to increase in value significantly more in the long-term than the short-term and because it will help you think of stocks as partial ownership of businesses.

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Disclosure: At the time of writing, Victor has long positions in Google and Disney, and no plans to change his positions within the next 72 hours. Will, the editor, has no positions in any of the stocks mentioned and no plans to change his position within the next 72 hours.

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