It's What You Know And Whom You Trust
A company that increases its earnings in a consistent and powerful way is a company whose stock will rise, no matter what. Over the long term, Brown writes, "among financial services companies, the piece of data that correlates most closely with a company's stock price is its earnings per share." Not the macro-economy, not interest rates, not P/E ratios. The catch is that the "correlation often takes three to five years to manifest itself."
But, if you think that a company's price will catch up to its earnings, then you shouldn't worry too much about the price when you buy it. Price is not unimportant, but becoming a partner in a good business for a long time is more important.
• Concentrate your holdings. Brown argues that "at any given time it's impossible to have a true knowledge advantage -- the investor's indispensable edge -- in more than a couple [of] handfuls of companies. If you diversify away from those few, you're only diluting your results. What's the point of that?"
But for most small investors, I would modify Brown's rule: Keep your portfolio diversified so that it looks like the economy as a whole and includes a variety of companies of different sizes and with both growth and value characteristics. But use your own expertise and that of concentrators like Brown himself to make choices in specific sectors and styles. Also, don't be shy about owning a lot of what you truly like, and beware of trying to keep track of too many stocks.
Brown writes, "We have had as much as 25 percent of our partners' equity in one position. That will make for highly volatile near-term results. But if you're a long-term investor, who cares? It will also help assure sizable long-term outperformance."
Remember, however, that academic research shows that while concentrated mutual funds beat diversified funds, focused portfolios carry higher volatility, or risk.
Consider American Heritage Fund (AHERX). A ranking in Business Week last month placed it No. 1 among all U.S. stock funds that don't focus on a single sector, from the start of 2004 through June 10, with a return of 22 percent. One-third of the fund's holdings are in just four stocks, each with a history of volatility: ADM Tronics (ADMT), chemicals and medical devices; UTStarcom (UTSI), telecom equipment; Micron Technology (MU), semiconductors; and E-Trade Financial (ET), online brokerage and banking. That's concentration, all right.
But American Heritage is a disaster. It is wildly risky, with a standard deviation (a measure of volatility) that is four times higher than that of the broad market, according to Morningstar. Over the past 10 years, the fund's average annual decline was 20 percent. In 1996 and again in 2001, it lost more than half its value.
On the other hand, Baron Partners (BPTRX), a mid-cap fund that owns just 26 stocks in all, has produced average annual returns of 16 percent during the past decade. The top two holdings -- ChoicePoint (CPS), which provides credential-verification services to businesses and governments, and Wynn Resorts (WYNN), which is building a mega-casino in Las Vegas -- represent one-quarter of total assets. The next four holdings -- Apollo Group (APOL), Netflix (NFLX), Arch Capital (ACGL) and Anthem (ATH) -- represent 18 percent.
So far in 2004, the fund has returned 17 percent, beating the benchmark Standard & Poor's 500-stock index by 14 percentage points. But the road has been rocky. Baron Partners failed to beat its category average in three of the past six years, and in 1999, the fund trailed its benchmark by an incredible 39 percentage points.
© 2004 The Washington Post Company