It's What You Know And Whom You Trust

Although investing is a subtle and complicated endeavor, everyone can benefit from a simple set of rules and principles. One of my favorite portfolio managers, Thomas K. Brown, chief executive of Second Curve Capital, a New York hedge fund that specializes in financial stocks, recently sent clients a little booklet called "My Ten Rules," guidelines for building "a long-term successful track record."

Brown was inspired by an excellent 2002 tome, "The Global-Investor Book of Investing Rules," in which Philip Jenks and Stephen Eckett compiled advice from 150 professional sages, including Marc Faber, the Hong Kong bear; Ralph Wanger, founder of Columbia Acorn fund (LACAX), one of the great small-cap funds; and Bill Gross, the bond guru.

Some of Brown's rules are obvious, others a bit technical. I have picked the five I like most and added comments.

• Play your game, not the other guy's. In other words, the way to develop an edge over other investors is to focus on what you know. That's what Brown does. He knows financial stocks. "When Capital One [COF] ran into some regulatory difficulties in 2002, for instance, the stock fell by 40 percent in a single day -- and then kept falling. . . . I know Capital One as well as anyone on Wall Street, . . . and I was sure the company's situation was not as dire as other investors believed. So as the stock was sold in a panic, I was a buyer." Capital One regained all it lost, and then some.

• If what you know is limited, don't worry. Brown notes that Warren Buffett says the size of one's sphere of influence is less important than the level of competence within it.

Every investor can develop such a sphere. Just look around you at work. If you're a dentist, think of companies that have invented new drills or that provide innovative software or simply do a reliable job of distributing supplies. If you're a consumer, check out the new chains at the mall. An alert shopper, for example, could have detected the turnaround at Coach Inc. (COH), the leather goods chain whose stock went from $5 in 2001 to over $40 today.

And, for Brown, a sphere of competence extends not just to subject matter but to style. Pick your strategy, he says, "and have the discipline to stick with it." Brown, for example, is a long-term investor.

• Own pieces of individual businesses at attractive prices, not "cheap stocks." This concept -- first formulated by the late Benjamin Graham, the Columbia University teacher and investor who was mentor to, among others, Buffett himself -- is by far the best way to think about investing in equities. Consider yourself a partner in a business, not an owner of a stock, Graham said. Or, as Brown puts it, "We see our portfolio as a collection of enterprises in which we own stakes, not a list of company stock symbols on a spreadsheet."

From this simple idea flows the notion that the price of a company on a given day is not as important as most investors think. "Who cares if you pay $31 a share for a given stock instead of $30 -- if you think its fair value is twice the current market price?" writes Brown. "What's the difference if the stock is 'ahead of itself' at $40 if you believe it's on its way to its $75 fair value?"

Brown says he obsesses a lot over a company's fundamentals, but "we spend less time on valuation" -- price-to-earnings ratios and the like. "We want to know how [a firm's] growth will be funded, and what will happen to any excess cash it generates. (By contrast, we don't spend much time worrying about how the current quarter is shaping up.)"