Top 10 rules for (really smart) investors

For all the fuss and bother, the market hasn't budged all year.

Yet some fund managers are already up to 12 per cent ahead.

Maybe they fluked it - only it just so happens that over three years they've also returned an average of at least 15 per cent a year, and in one case 31 per cent.

How do they do it?

Well one secret is they count dividends, and so should you.

Even so, it's some achievement to be earning dividends as well as making capital gains. Ah, them were the days.

While the mind boggles how they'd go if the market ever does something, the point is they're buying.

Here's how they go about it:

1. MAKING MONEY

Got you first go. There's making money and there's pretending to.

"It's not the reported profit but the cash profit that counts," says the chief investment officer of Clime Investment Management, John Abernethy, whose Australian Value Fund has been returning an annual 15.3 per cent for three years.

The cash profit removes accounting complications such as depreciation or cheques that might get lost in the mail. It's more brutal with the truth.

Still, the reported profit has its uses, especially when you look at it over time.

"You want a three- to five-year consistent track record with a return on equity not below 15 per cent," Abernethy says.

The return on equity is after-tax earnings divided by the number of shares.

Still, no point being dogmatic. Legendary fund manager-turned-private investor and philanthropist Laurence Freedman likes to be there before a company makes a profit. Sometimes he's too early (if this has happened to you, skip to rule 10 - but do come back. We'll wait for you.)

"The transition I look for is when it first makes a profit because that's when you get the kick up," he says. "So I want to be in it before it's profitable. Then the stock becomes known and there are no sellers."

2. BUY BARGAINS

The reason the best investors are back in the market is because it's cheap. There are stocks that own more than they're valued at. "Don't pay what you think the shares are worth. Pay a discount," Abernethy says. So not only do you have to work out what a stock is worth, you have to pay less for it.

Check how much cash it has, and the reported book value.

Although you want to avoid penny dreadfuls - unless you're after a punt, and, remember, that's all it is - the smaller the stock, the greater the potential and the more likely it is to be undervalued because nobody notices it.

"We choose stocks outside the top 100. There's 2000 to choose from and that means there isn't such an efficient market," the chief investment officer of Celeste Funds Management, Frank Villante, says.

As his fund's average annual three-year return of 16.6 per cent proves, the less efficient the market is, the more chance you have of beating it.

In fact, Freedman argues that blue chips only drag you along with the herd.

"Analysts follow each other. They could all be wrong or right. Effectively, it's like buying the index, which is a lousy place to be."

3. BEST AT ITS GAME

"You don't want just businesses that benefit from the [economic] cycle. You want a competitive advantage in industries with a significant tailwind," says Sebastian Evans, portfolio manager at Naos Asset Management, which has been producing a 31 per cent average annual return for three years, according to Morningstar.

Even better if nobody can touch it. Prompted by its "high barriers to entry", he bought into iProperty Group (IPP) when it was worth only one-fifth of today's value.

To get a 31 per cent annual return he can't be going into the stocks everybody else is, either.

"I don't want to invest in mining services because someone says it does work for Rio Tinto, not with a [price/earnings] multiple of 10. There's no competitive advantage because it's just a leverage play on commodity prices," he says.

"And contracts can get pulled."

4. FEEL THE QUALITY

Just as important as what a stock makes or loses is what it owns and owes.

That's where the balance sheet comes in.

Although this is useful for working out all manner of financial ratios, the best money makers use them as a guide only, not a rigid rule.

A figure is easily fudged, too, as Wayne Swan can tell you.

"You think it must be right, but not necessarily. It's just a snapshot and may have been beautified," Villante says.

5. AVOID DEBT

The less debt the better, both the company's and your own.

"Debt in a small company can kill you in this market," Freedman says.

The "interest coverage", which is pre-tax profit divided by loan interest payment, can be a dead giveaway.

The higher the better - you'd want it to be at least four - because it shows how easily the company can meet its loan repayments.

Oh, and don't get into debt yourself. This is no market for margin loans.

"Don't gear in this market. There's too much uncertainty. Even though debt is cheap there's too much risk," Abernethy says.

6. MEET THE MANAGEMENT

The toughest task for investors is getting to eyeball executives, though long before he became a billionaire investor, Warren Buffett would just turn up and ask for a meeting. It was usually granted, too.

Successful fund managers spend half their time visiting companies. It's the sharemarket version of tyre kicking.

The next best - though more boring - thing is to go through the accounts forensically. They'll give you a good idea whether the company is stretching the truth.

One trick Abernethy suggests is going back to annual reports two or three years ago and comparing what was said with what was done. Also look at the bone fides of the board.

"You have to feel fundamentally compatible with the board because it appoints management," Villante says.

One thing's for sure: you want executives to have skin in the game.

"A manager should have a long track record of performance and own a material number of shares," says David Prescott, a director and portfolio manager of Lanyon Asset Management, which has returned 11.2 per cent in six months.

7. ON ITS OWN FEET

Who needs a stock asking for money all the time? "Avoid companies raising equity rather than funding growth from growing profits. Otherwise it's using your money for its own management," Abernethy says.

"Go back to 2008. If it didn't raise money in the GFC that's a big tick. Some that did are coming back again for more money."

8. ALL STOCKS ARE RELATIVE

The bottom drawer doesn't work any more because you can miss better, and possibly safer, opportunities.

"We sell if we've got a 15 per cent return and something comes along with a 30 per cent return," Villante says.

9. SOMETIMES SELL

Say goodbye to duds and sell good shares when they're overvalued. No, don't hang on to a stock forever because it's doing well.

When you buy you should have valued the stock, and when the market goes past that it's time to sell. "Sell when a stock is no longer undervalued," Prescott says.

10. BIT BY BIT

Nobody can pick the top or bottom of the market, although the top money makers seem to have an uncanny sense of timing.

But they rarely buy in full bore.

"Buy a bit and use dollar-cost averaging. There's no hurry. Don't pay today's prices," Abernethy says.

Stocks that stack up

What top fund managers are buying:

Aeris Environmental (AEI)

ARB (ARP)

Bionomics (BNO)

Blackmores (BKL)

Cabcharge (CAB)

Fleetwood (FWD)

Ingenia (INA)

iProperty (IPP)

MACA (MLD)

Oakton (OKN)

Oroton (ORL)

Photon (PGA)

Phoslock (PHK)

Nanosonics (NAN)

Village Roadshow (VRL)