An esteemed colleague recently moved on after 12 years with Intelligent Investor. During that time, his entire approach to investing underwent something of a revolution. This week I'm sharing his 10 most important tips for successful investing.
Portfolio weightings matter Sensible capital allocation is essential. Evaluate how risky a business is and allocate capital accordingly. Speculative stocks should be limited to 2 per cent to 3 per cent each (or avoided altogether). Conversely, when a high-quality business you own becomes very cheap, buy more. Diversification is important, but none of us is Warren Buffett, so don't make huge bets on a single stock.
Make fewer, but better, decisions. Try to avoid being distracted by mediocre companies at reasonable prices wait for standout companies at bargain prices. Two or three a year might be all you need to build a decent portfolio over time.
In the past, my colleague had done well buying small, cyclical stocks when they were very much out of favour. Since the global financial crisis, he has wondered whether it was the bull market that saved him. These stocks have generally gone from bad to worse since the GFC. The businesses that have held up best have been quality holdings - big, well-managed companies with solid balance sheets. Make these the backbone of your portfolio.
There was a time when he thought management was almost irrelevant. Buying a mispriced stock was far more important. Having seen what happened at funds management company Perpetual during the past decade, he now believes management - and, in particular, management changes - need careful consideration. Because he now prefers to own businesses for a long period, management's capital-allocation ability needs very close scrutiny.
Price paid matters
Past mistakes such as Sigma Pharmaceuticals made him question whether he was overpaying for quality. He sometimes struggled with the idea of paying for quality in his own portfolio, which is perhaps why it often contained a smattering of cheap cyclical businesses. Now, he thinks you should pay for quality, but not by too much. Mr Market provides infrequent opportunities to buy good businesses at reasonably cheap prices.
Big winners matter
Instead, you could say, "Don't sell quality companies too soon," but this is one of the biggest and easiest mistakes to make. Deeply underpriced, high-quality companies are rare don't let them go just because the share price has risen. Let compounding work its magic over time. When your broker says, "You never go broke taking a profit," tell him, "Well, you don't get rich taking one prematurely, either."
Free cash flow matters
Shamefully, there was a time when he gave the cash-flow statement only a cursory glance. Now, it's the first financial statement he turns to. If a company isn't producing reasonable free cash flow, then it's very unlikely to enter his investment universe. Asset-heavy businesses that require a lot of capital expenditure rarely produce much cash for shareholders.
The seller matters
Or, "Don't buy anything from private equity." In the 1990s, before the private-equity boom, you could do well buying company floats. Those days are gone a lot of new floats are debt-laden, hollowed-out shells, sucked dry by their private-equity owners. Generally, you will be well served by ignoring most private-equity offerings.
In the past, he followed Peter Lynch's maxim: "If you spend 13 minutes a year on economics, you've wasted 10 minutes." Lynch's assertion is that economic forecasts are useless, but what the period since the GFC has shown is that economic issues are important. You should be thinking about inflation, the housing market, the Aussie dollar, the sustainability of the euro and other risks. Otherwise, you could expose your portfolio to wipe-out events.
It's easy to become despondent when your portfolio is performing poorly. But never forget that your partner, your family, your health and your friends are more important than anything else. Work and investing is only ever a small part of your life, so don't neglect the rest. Take time to stop and smell the magnolias.
Nathan Bell is the research director at Intelligent Investor, intelligentinvestor.com.au. This article contains general investment advice only (under AFSL 282288).