Characteristics of a Winning Investment, Part II

Generally the stocks I single out for investigation on this blog share many traits. In an ongoing series I outline the qualifications of these story-stocks.

When I invest in a particular stock, I'm really investing in the people employed by the corportation. While I do not know them generally, it's easy enough for me to find out certain things about them. The first thing I want to know is whether they believe in themselves. This, I can ascertain by investigating the level of insider ownership.

Insider ownership is represented by the percentage of outstanding shares in a public company owned by the directors, managers, officers, or others who have key 'insider' knowledge of the operations of said company.

In a general sense I'm looking for corporations whose insiders own at least 10% of the operation. This indicates that the interests of those in charge of the outfit will be compatible with those of the shareholders. Namely, both hold a significant financial interest in the performance of the stock.

It's not suprising that many of the wealthiest men in America, including the top dog Bill Gates, have achieved their enormous riches by partaking directly in the exponential growth of the world-changing enterprises they oversee.

If one owns 857,499,336 shares of Microsoft (MSFT), then one is Bill Gates and he should be too busy to read this blog.

But, joking aside, it's clearly evident how Mr. Gates, and others in his position, benefit by appealing to investors (especially of the institutional variety) and taking actions that best serve the stock price over the long run.

Therefore I consider it a net positive for a company's insiders to hold a significant stake in the outfit. And when insiders purchase company stock on the open market, it's an even more bullish sign. For insiders may sell for any one of a million reasons, maybe their child is off to college or perhaps they're buying a new home. But insiders only buy for one reason: They think the stock, and very often with good reason, is going to go higher.

While not an ironclad rule, the stocks you'll see profiled on story-stocks generally possess a high percentage of ownership by insiders. It isn't a requirement per se, but it's absolutely a good rule of thumb.

Dislosure: I do not own shares in any of the companies mentioned.

Stock Market Riches on $3 a Day?

Let us imagine that you're just starting out. Maybe you're working a 9-to-5 and your pocketbook isn't exactly overflowing with disposable investment income. Still you'd like to build up some measure of a nest egg for the future. Happily, I can report, you are not out of luck.

The first step requires that you take inventory of your financial situation. Full time wage earners in the United States earn a minium wage of $5.35 an hour. Hopefully you're doing a little better. But let's say you're not. How can a person earning $42.80 for each eight hour shift save anything with which to invest.

Admittedly, it won't be easy. But imagine you could place just $3.00 aside each day. That would add up to $1095.00 a year. Obviously, we are beginning to arrive somewhere.

Saving $3.00 a day might take a little sacrifice. Perhaps you could do without your morning latte, substituting a cup of Folger's at home. Such a small, and in the grand scheme, insignificant sacrifice can pay big dividends down the road. David Bach calls this the latte factor. (He's even trademarked the name.)

So you're doing without the latte or you're washing your own car (or whatever it is) and are able to set aside $90.00 this month. Congratulations. Now you're going to need a place to sock the cash. I recommend that you set up a cybersavings account at a place like ING and reroute the cash into an interest bearing account. This is fairly easy to do. It's a point, click, and type in a few account numbers.

Setup your ING account to automatically deduct this amount monthly from the bank account in which you deposit your check. (Also, easy to do.) Next you'll need to open an account at Sharebuilder (coincidentally owned by ING). With this account you'll be able to purchase stock at $4.00 a transaction. It's a little pricier to sell, at $14.95, but since we're accumulating wealth, we're not planning on selling until we've build up quite a bit of equity.

Every four months instruct your Sharebuilder account to debit your ING account in the amount of $360. And buy some Standard & Poors depositary receipts (SPY). (NOTE: I do believe that one can earn a superior return through individual securities but, for the purpose of this article, I am recommending SPY.) The S&P has averaged an 10.43% annual return since 1926. Forty one percent of this return has come from dividends, so make certain to set your Sharebuilder account to reinvest those for you. (Sharebuilder will reinvest dividends free of charge.)

You can set all this up in about an hour. And then you just have to forget about it. The rest of the work will be done for you by market forces.

A word of warning: You won't receive 10.43% return on your money this year. That number is an average. Some years the S&P will gain 25%, some years it will lose 15%. Over time it would be reasonable to expect a return in the ballpark of the 10.43% historical return.

Let's take a look at how you'd fare over various time intervals.

After 4 months you'd have $360. One year, $1095. After two years the amount increases to $2,418.41. At the end of five years your kitty would be worth $7,275.95. Keep up the savings for another five years and you'd accumulate $18,886.23. After twenty years you'll be sitting on $70,608.50. Finally, forty years from now, when you're thinking about retirement, this one action, saving $3 a day, will have produced $586,300.39.

Not too shabby, huh? Now imagine if you could only save $5.00 a day. For further reading, I highly recommend the works of Mr. Bach.

Why Mutual Funds Fail To Beat the Market

Perhaps you have heard that 75% of actively managed mutual funds will fail to keep pace with the general market over any significant period of time. Well, you heard right. With history as my guide, I can confidently proclaim that the vast majority of mutual funds will underperform the market over the next five years.

There are a number of reasons for this. Let's look at a few:

1. Mutual funds are often overdiversified.

A diversified mutual fund must hold a minimum of 20 stocks, with many funds owning over 100 or even a thousand individual securities. As you might imagine it's difficult to reap the rewards of a big winner if it represents 1% of your total assets. Furthermore, who has 100 or 1000 good investment ideas at any time. Of course that's not the only reason funds fail to outperform the market.

2. Mutual fund managers must invest even when they believe the market is overvalued.

When a mutual fund has a successful period a boatload of new money often flows into it. The fund manager is forced to put this money to work buying more shares at a considerably higher cost or initiating new positions. A fund manager often can not or will not hold a significant cash position in wait of a better opportunity.

3. Even no-load funds bear expenses for shareholders.

All mutual funds have an annual expense ratio (the average for a stock fund is 1.4%). In effect the fund must outperform its respective benchmark by the amount of its expense ratio just to meet the return of the market. For instance, a general equity fund may charge you 1.25% for the honor of managing your money. But if it does not beat the S&P by about 1.15% (the SPY carries a .08 expense ratio), you're losing money.

4. Mutual fund managers must report their holdings quarterly.

It's often been said, and I believe it's true, that no money manager ever lost his job investing in IBM. It's a simple fact of life that no one wants to look foolish. So creativity is severely lacking among this group of professionals.

Now, all of this is good news. If you're invested in actively managed domestic mutual funds, get out now. And where should one stash one's cash? In an index fund? Well, I don't believe that's the most appealing option either as $10,000 invested in the S&P 500 10 years ago would be worth just $14,800 with all dividends reinvested. That clocks in at just over a 4% return annually. Hardly anything worth writing home about.

If you have the time and the inclination, I believe you'd do best in individual stocks. You do not have to overdiversify. Your expenses are limited to trading costs ($7 a trade). You're never forced to buy. And you don't have to publish your results for the world's inspection.

So that begs the question, "What do I invest in?" Now your starting to talk my language.

Scour the web. If you're reading this blog, you've taken an important first step. But don't stop there. Check out the resources listed in the sidebars. (I think Peter Lynch's One Up on Wall Street is a great place to start.) Read the Motley Fool. Create a model portfolio on Yahoo! Finance. And save, save, save.

After all, you have the advantages. The only thing the professionals have in their corner is an element of fear. They want you to believe that you can't manage your own money, that you'll somehow lose it all. The reality of the situation is that it's likely you'll do better than they will.