401(k)s: "Focus on the Remaining 60%"

Don't chase the 40% you've lost, says investment adviser Michael Farr. Figure out how much risk you can take with the rest

Invest when you have the money, in stocks with low valuations and high earnings growth. That's the formula recommended by Michael K. Farr, president of investment firm Farr, Miller & Washington. As for stocks he might buy now for his customers, he names Honeywell, Wendy's, Target, Pfizer, and Capital One, among others.

For the long term, Farr is high on index funds provided the investor sticks with them through difficult times. He points out that 80% of investment managers fail to meet the performance of their benchmark indexes. Farr made these and many other comments in a chat presented July 25 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Edited excerpts from this chat follow. A complete transcript of this chat is available from BusinessWeek Online on AOL, keyword: BW Talk.

Q: What criteria would you suggest for picking stocks in this volatile environment?


I look for stocks with low valuations and high earnings growth. I like to see strong fundamentals, and strong management is a must. Those are essentials for a long-term investor. Almost every stock over the past six months, even those with the strongest fundamentals, have come down. So [even] people who have invested based on the very best criteria and after extensive research have lost money.

If you're a long-term investor, you can take some consolation in knowing you didn't make your investment to see where you [would be] in three months. And if you want to add to your investment now, based on the research you did...you will likely be rewarded over the long-term horizon that was your original investment thesis.

Q: What if you're 59 and trying to recoup 40% losses on your retirement funds? An all-too-common dilemma these days.


I have had many similar questions over the past few months, and they are among the most difficult and painful. The market has come down well over 40% from the highs in March, 2000. Making up those losses will take, by reasonable historic measures, 9 or 10 years if we have a normal market environment.

So the advice to those with significant losses is: Forget the losses. Focus on the remaining 60%. Determine a reasonable amount of risk for a 59-year-old, for that amount of money. Establish reasonable goals, and establish an investment architecture that's comfortable and conservative that will produce reasonable goals for that amount of money.

Trying to recoup the 40% as your investment goal may lead you to take a great deal more risk than would be appropriate for your age and retirement goals. In short, I'm not sure it can be recouped in the time period before your scheduled retirement. Don't swing for the fences -- the conservative road will still be the best and most comfortable for you over time.

Q: What's your opinion of stock index funds at this time?


I'm in favor of stock index funds in almost all markets for long-term investors. In most markets, 80% of the professional managers fail to meet the performance of the benchmark indexes. Given the low fees associated with index funds and their long-term historical performance, I think they're good vehicles for investors [who] have the discipline to stay in them through difficult times.... Everybody is a long-term investor in bull markets.

Q: Would you stay liquid or jump in now? For example, Coca-Cola (KO ) looks like such a good buy.


If you're a long-term investor and believe that at some point in the future returns on equity investing will be superior to fixed-income investments and therefore better meet your needs and goals, then the best time to invest is when you have the money.

It's not dependent on market conditions. It's not a matter of jumping in or out. It's a matter of finding good-quality companies that you can buy and hold for the long term, that you can buy and hope that management, the industry, market share, etc., will produce value for you over the years. You need to buy a number of different stocks in a number of different industries, diversify your portfolio in order to limit the risk, and be very patient. And yes, I agree that Coca-Cola looks pretty good at these levels.

Q: What ratios or set of numbers do you examine most closely when evaluating a stock?


I look at several measures. I look at sales. I look at earnings. I look at the price-to-earnings multiple, I look at the p-e multiple vs. the past five-year growth rate vs. the projected five-year growth rate. I look at sales growth -- I look at projected sales growth vs. future bottom-line growth.

Whatever numbers you choose to use, the important thing is to be consistent about their application. Be disciplined in your adherence to them, because that consistency will see you through the emotional markets.

Q: What are you buying now?


We will buy a variety of securities for clients whose accounts we manage, based on the needs and goals of those particular clients. That said, some names where I see some value today that I might add to clients' accounts are American Power Conversion (APCC ), Honeywell (HON ), UPS (UPS ), Target (TGT ), PepsiCo (PEP ), Wendy's (WEN ), Sysco (SYY ), Pfizer (PFE ), Waters (WAT ), EMC (EMC ), Dell (DELL ), Microsoft (MSFT ), Wells Fargo (WFC ), Capital One (COF ), AIG (AIG ), and the Scudder New Asia Fund (SAF ).

Q: When are these excesses for CEOs stopping? It's totally unfair that they get these huge amounts of compensation and stockholders are left holding the bag!


Amen, amen, amen! Somehow, corporate CEOs in the U.S. feel entitled to millions and millions and millions of dollars in compensation to be given to them simply because of their anointment as CEOs, even without regard to performance.

The excesses in compensation have become absurd. The boards of directors have become an old-boy, marquee-name society, where name and connections have precedence over experience and expertise. This has to stop -- I believe that process is well under way, but it cannot be implemented fast enough. And if a CEO delivers great value for his company, then I'm all in favor of paying him.

But I don't think that we can continue to compensate without performance. You and I are not compensated regardless of performance. It makes no sense that these corporate titans shouldn't be held to the same standard.

Edited by Jack Dierdorff

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