July 09, 2004, 8:40 a.m.
The Pick of Brown’s Litter
The simple rules every investor should know.

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.)"

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.

When a fund like Baron Partners is simply a part of your portfolio, its volatility is diluted by the more consistent performance of other funds and stocks. Don't be afraid of concentration, but be wary of too much.

Don't get overwhelmed by numbers. "Mastery of minutiae does not equal insight," writes Brown, expressing unusual sentiments for someone who is an accountant by training. Wall Street, he writes, "is full of intelligent people who unfortunately like to spend too much time bathing in data." Riveted by a company's numbers, these folks "ignore that environment in which the numbers arose, and arrive at crazy conclusions."

Brown warns, for example, not to become transfixed by rising revenue (since those added sales may be unprofitable), not to be dazzled by the predictability of results (since management may be artificially creating consistent numbers at the long-term expense of the business) and not to be afflicted by the Wall Street malady of concentrating on just a single piece of information as shorthand for the health of the whole enterprise ("net interest margin, loan loss reserves, you name it").

Remember, he says, it's the business that gives rise to the numbers, not the other way around. Use the numbers to understand the business, but don't let the numbers take on a life of their own.

Evaluation of management is critical. My shorthand is, "Invest in people, not stocks." Brown says that if he doesn't know a company's senior management, he "won't own a meaningful position in the company." When he gets face to face with the top executives, he uses some tricks "to find out whether a management is the real deal."

First, he visits the company on its own turf since a chief executive "is never as complacent and unguarded as when he's sitting behind his own desk." Second, he watches body language. "Fidgets can speak volumes." Finally, he listens to be sure that everyone on the team is on the same page. He asks the same questions over and over, with slight variations, of different people. "You won't believe what you hear sometimes; you'll wonder whether the guys are from the same planet."

A smart management team, Brown writes, "knows the business it's in, knows its company's strengths and weaknesses, and knows its numbers cold. The members of the team communicate with each other, clearly and regularly." The team "wants nothing better than to win, and knows how to."

The problem for small investors, of course, is getting access to managers in order to make these judgments. In most cases, you won't be able to. But, sometimes, you will be able to size up a chief executive, who may be a neighbor or a friend of a friend. Take advantage of the opportunity; it may come just once or twice in a lifetime. And, in the meantime, invest in mutual funds whose managers take Brown's approach and assess not only a company's fundamentals but also its leaders.

— James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com. He is also a member of Intel Corp.’s policy advisory board. Of the stocks mentioned in this article, he owns Apollo Group, Netflix, and Capital One. This article originally appeared in the Washington Post.