02:37 | Posted by The Correspondent

The New Rules of Building Wealth

Beat the S&P (and your hedge-fund buddy) with 8 simple tips from the most trusted financial brains in the game

Mark Adamle remembers the exact moment when he strayed from the rules of investing. It was December 1999, the world was still giddy with dot-com millionaires, and he had just come into his tidy Christmas bonus. Who could blame him for reading a business-magazine article about which stocks to own for the next decade?

So half of his bonus went straight into WorldCom, and the other half into Lucent Technologies. You can guess how this story turns out. "I was smacked around pretty good," says Adamle, 47. "I thought I was a gunslinger, and I got burned."

That's when he rediscovered his humility, stuck to some core principles of investing, and got his portfolio back on the right track. After all, Adamle—a senior VP of Intersport, a sports-programming producer for networks like ESPN—had been a pretty good saver over the years, ever since marriage and his two kids entered the picture. Now, by sticking to his rules, and with the help of his financial planner, Ray Evans, he's been able to rack up solid 16 percent annual gains.

By opting for a long-term time horizon, improving his asset allocation, avoiding the turkeys with sketchy earnings reports, and keeping his emotions out of his investment choices, he's been able to secure his retirement and prepare himself for those upcoming college bills. "I've always been involved in sports, and in sports there's a win-or-lose mentality," says Adamle. "The same goes with investing...and no one likes to lose."

To help you win the investing game over the long haul, we sought out the wisdom of some of the most brilliant financial minds in the country—not just any mutual-fund managers, for instance, but individuals who collectively manage about $20 billion and consistently outperform their peers year after year. We asked each finance guru for one important rule that has guided him, and that you can bank on yourself. The result is a master course in investing. Class begins now.

Forget performance; look at fees
So you've done your mutual-fund screens, crunched the Morningstar ratings, and come up with the top performers. Now take all that data and throw it out the window, because it's not past performance but low fees that will likely determine your ultimate financial success.

"Any economist will tell you that in terms of predictive power, there's no comparison," says Mercer Bullard, founder of investment-world watchdog Fund Democracy and a visiting professor at Washington University in St. Louis. "In a given investment category, if you're to pick a single factor to go on, you're going to do better in a fund with lower costs."

We're not just talking about load funds: No-loads have the seemingly tiny expense ratios that can make a massive difference to your retirement kitty. Take this example from fund giant Vanguard: Consider $5,000 investments into two funds—one with a 1.3 percent expense ratio, the other with 0.3 percent—and subsequent annual investments of $5,000, with an 8 percent annual return. After 20 years, that minuscule fee spread is going to cost you more than $28,000.

But you might not learn this from Morningstar fund research, says Bullard, since it doesn't break out fees as a separate factor for fund evaluation. Nor does the Securities Exchange Commission help with legislating more fee transparency. Still, investors are catching on, directing more and more of their asset flows to low-cost funds over the last 10 years. ETFs, or exchange-traded funds, are another way to get a basket of securities and chop expenses back. "Every basis point matters," says Bullard. "If I had to choose between eliminating mutual funds that are the most expensive or those that are the worst performers, I'd eliminate the most expensive ones."

Invest when a stock's earnings estimates are being revised upward
Sorry to say, but when it comes to investing, the deck is usually stacked against the individual. Big institutional money moves markets, leaving the scraps to the rest of us.

In certain rare cases, it's the individual who actually has a leg up. And one of those instances, according to portfolio manager Mitch Zacks, of Zacks Investment Management, is when a stock's earnings estimates are consistently being revised upward. "It's the most powerful force affecting stock performance," says Zacks, who's headed up the Chicago-based firm for 10 years. "Not only will improved earnings increase the intrinsic value of the stock, but also companies receiving upward revisions are more likely to receive them again in the future."

But why does Joe Average hold the upper hand in this scenario?

Because the institutional players—such as a huge Fidelity mutual fund—are lumbering organisms that don't move all that quickly in reaction to earnings news. "Their decisions are made by committee," says Zacks. "They think about it, they meet, they discuss, they get analysts to review the situation, and only then do they decide to purchase." Meanwhile, you've hopefully scooped up the stock and seen some quick gains.

For an easy way to find out whether a company has a history of upward revisions and positive earnings surprises, check out zacks.com, a free site that also has a premium "Advisor" service. Zacks ranks stocks based on a five-point system, and sample portfolios based on this metric have racked up 30 percent annual gains for the past 25 years. We'll take it.

Monitor cash flow to find winners
Earnings numbers are the definitive blueprint for figuring out how a company is doing. So why are so many money managers these days looking at another, but related, marker?

It's free cash flow, and it's an extremely honest indicator of company fortunes. Basically, it reveals how much money remains in corporate coffers after the bills are paid and all the dividends are distributed. It's much harder for a firm to get away with financial shenanigans and a questionable quality of earnings reports when you're looking at the hard facts of how much scratch is left at the end of the day. Finance.yahoo.com, for instance, has a helpful "cash flow" option that separates out that information for you when you're researching a stock. "It's what the true value of a company is," says Bob Smith, vice president of fund giant T. Rowe Price and manager of its Growth Stock Fund.

It also helps narrow down your universe of potential investments, because extremely few companies are able to increase their free cash flow at double-digit annual rates. If you find that, you've identified a winner, and a metric that's going to move that stock upward in the future, not necessarily in the short term, when stock movements can be wildly unpredictable, but over a long-term horizon, when looking at free cash flow becomes essential for making money.

A few stellar companies that have pulled off the double play of generating lots of free cash and putting it to good use, according to Smith: Wal-Mart, Citigroup, General Electric, and Microsoft. "Usually you have to pay a premium for these franchises, and now you don't. They're all very attractive right now," he says.

Put the right investments in the right places
You might think that the big challenge of investing is picking the right stock or fund to add to your portfolio. But you'd be only half right, according to asset-allocation king Roger Ibbotson, chair of Chicago's Ibbotson Associates and a professor at the Yale School of Management. Where you slot that investment is what's really going to determine the quality of your retirement.

That's because Uncle Sam will want his cut of your gains, and how you manage that eventuality is the most critical move of all. That cut may be nothing, or it may be 35 percent or more. It all depends on what you put where. "The issue of taxes completely swamps the question of what particular stocks you might have bought over the years," says Ibbotson. "It dominates over the long term."

His advice: Hold highly taxed assets—such as taxable bonds, equities that throw off plenty of dividends, and mutual funds with lots of trading activity—in your tax-deferred or tax-exempt accounts, such as an IRA. Max out contributions to those accounts, and when you make your withdrawals, you'll likely be in a much lower tax bracket. In your taxable accounts, house investments like your tax-free municipal bonds. Frequent traders should keep in mind that capital gains on investments held for less than a year are taxed at the full 35 percent rate. "People might have the right investments but in the wrong accounts," says Ibbotson, "and they don't even know it."

Forget 1-year outlooks; plan at least 5 or 10 years ahead
Chess grand masters don't think about just the move of the moment. They're thinking about what the chessboard is going to look like seven or eight moves down the line. You should look at your personal- wealth situation in the same way, says Dan Fuss, vice chairman of investment firm Loomis Sayles. "It's human nature to look at a 6-month to 1-year time horizon," he says. "But you have to look much farther out than that and figure out the longer-term trends."

Fuss, widely regarded as one of the top bond-fund managers on the planet (he heads up the Loomis Sayles Bond Fund and has been tapped by Morningstar for his outstanding performance), says his advice applies to any asset category you'd care to think of. Real estate? Consider trading in your adjustable-rate mortgage for a 30-year fixed, because the Federal Reserve Bank is continuing to hike interest rates, and it could hit you right in the pocketbook when your rate begins to float.

TIPS, or Treasury Inflation-Protected Securities? They might look attractive right now because of inflation fears, but keep in mind that the Treasury is planning on rolling out more and more TIPS, so beware of oversupply. Stocks? Earnings for your widget manufacturer may be stellar now, but if the Chinese are starting to make widgets (and you can bet they are), then your financials 5 years down the road may turn into a horror show.

And for Fuss' comfort zone of credit, the same principle of longer-term thinking applies. Consider emerging-market bonds, since the fundamentals abroad are improving, thanks to a white-hot commodities market. And in a rising-rate environment, focus on investments with shorter maturities. "Be careful of taking on long-term risks," he says. "It's better to avoid it right now."

Don't be afraid to hold cash
It might seem bizarre for one of the top money managers to counsel hoarding cash. After all, equities have a long-term average of 10 percent annual gains, while your cash will do little more than sit in a bank.

But look at Bob Rodriguez's record, and it pays to listen to what he's saying. As a portfolio manager at FPA Capital, his fund has returned an eye-popping average 17.9 percent over 20 years, according to research firm Lipper. This is one of the best all-time records of any fund, anywhere. "The most aggressive asset I've been acquiring in the last year is cash," admits Rodriguez. In fact, his fund is now up to 46.7 percent cash.

Why? Because the value-oriented Rodriguez just doesn't see any attractive buys out there. So he's perfectly content to sit and wait for an opportunity to offer itself. Such was the case a few years ago, when he and his analysts thought that the energy sector was supremely undervalued—some companies were selling at less than the value of their drilling equipment alone—and bet heavily on it. Looking at today's gas prices, that bet has paid off for him handsomely.

Patience is actually the most rare of investor virtues, says Rodriguez. If you find an out-of-favor company that is in an unloved sector but is a market leader and has solid executives in place, then by all means, buy it. But if not, it's no sin to hoard your money. In fact, Rodriguez's favorite place to put his money right now is short-term T-bills, and he feels that yields are not yet high enough, given the deteriorating U.S. balance sheet—loaded down with the costs of the Iraq war, drug benefits, and Katrina reconstruction.

Follow the outstanding shares
Traditionally, stock buybacks were a solid indicator of a company's encouraging financial future. If a firm spent its free cash snapping up its own shares, it demonstrated the executives' faith in the company, and their belief that the stock was undervalued and would prove to be a terrific investment.

Indeed, buybacks can still be positive. But beware of the bandwagon. It seems everyone is engaging in the practice these days—Wachovia, Exxon, Cisco, Wal-Mart, and so on—and it's getting harder to tell who's doing it for the right reasons and who's doing it simply because they don't know where else to put their cash.

One marker, though, is a helpful tip-off: a company's number of outstanding shares. A key rationale for buybacks is to reduce that number, thereby increasing earnings per share and boosting the company's overall valuation. But only 39 percent of companies buy back stock for that reason, according to Howard Silverblatt, Standard & Poor's equity-market analyst. Others might do it to boost mergers-and-acquisitions activity, like buying another company with stock. Firms such as Dell have been gathering stock for years without reducing the total number of outstanding shares, says Henry McVey, chief U.S. investment strategist at Morgan Stanley.

So if you're tempted by a buyback announcement, consider sticking to those companies that have been reducing their total outstanding shares. The resulting increased earnings per share should hold you in good stead.

Don't rely on your instincts; they're probably wrong
It's kind of like George Costanza's famous dilemma on Seinfeld. Every natural instinct he possessed was terrible, which meant the opposite instinct had to be right. And so it is, unfortunately, with our investing behavior. "If people always acted rationally, then no one would ever make mistakes," says Markus Brunnermeier, a behavioral economist at Princeton University. "But once you introduce human judgments, then you're in the area of irrationality. And when it comes to investing, people have many biases."

The foremost example: overconfidence in one's own stock-picking abilities. We all think we're the second coming of Warren Buffett, when we most certainly are not. And the more complicated a task gets (such as deciphering a dense earnings report), the more overconfident we become. We also tend to engage in "feedback trading," or buying stocks that have done spectacularly well in the last quarter, though history has shown that chasing recent returns is absolutely the wrong way to invest. We tend to sell our winners and hold on to our losers, because we don't want to admit we were wrong (called "cognitive dissonance" in the psych world). We ride the most ridiculous bubbles, even when we know the assets are way overpriced, because we don't want to miss out on the gains. And the list goes on.

Given that we're all imperfect beings, how do we get past all this and make smart decisions? Invest a large fraction in index funds, for one, which takes our terrible stock-picking abilities out of the equation. Brunnermeier, for instance, has part of his own money in index funds; Vanguard is the most prominent index player with excellent cost efficiency. Diversify to get away from our tendency toward "narrow framing," or focusing on one aspect of our portfolio and forgetting about the total picture. And write down your goals in advance—for example, your plan to sell a stock when it drops below $40—so your emotions don't run the day. Mark Adamle learned the hard way: "In the past, I jumped on the bandwagon," he says. "Now I don't invest emotionally or get caught up in the mania."

Posted by The Correspondent on 02:37. Filed under Time-Money . You can follow any responses to this entry through the RSS 2.0. Feel free to leave a response

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