Some Rules for Stock Success

Morningstar's Patrick Dorsey's new book lays down the guidelines. Among his tips: Never leave too many eggs in one basket

One way to identify a good candidate for your investment money is to see if the company has an "economic moat" -- something that strongly distinguishes it from the competition and protects its franchise. That's one of the principles enunciated by Patrick Dorsey, director of stock analysis for Morningstar, in his new book, The Five Rules for Successful Stock Investing.

Dorsey names Coca-Cola (KO ), eBay (EBAY ), and Dell (DELL ) as companies with a moat. Among his other rules, he tells investors to do their homework, including studying a company's 10K filing, and to buy stocks for less than their apparent worth. The latter is difficult these days, because Dorsey sees most stocks in the Morningstar universe as overvalued by about 10% -- and 30% in the case of technology stocks.

However, he does see a few interesting plays, including Barra (BARZ ) in tech, a purveyor of risk-management software; TransCanada PipeLines (TRP ) in energy; and Novartis (NVS ) and Merck (MRK ) among the pharmaceuticals. On the question of investing in emerging markets, he advises waiting until there's "blood in the streets," and then buying when other investors flee.

These were a few highlights of Dorsey's remarks in an investing chat presented Feb. 26 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Pat, the market hasn't seemed to be getting anywhere the last few days. Are we in a correction?

A:

I have no idea, since trying to call short-term market movements is a fool's game. That said, the market is expensive, and I hope we're in a correction because that will mean lots of great buying opportunities.

Q: How much of a correction would produce great buying opportunities?

A:

At the moment, the average stock in our coverage universe is trading about 10% above its fair value. High-risk stocks are particularly overvalued, at about 30% above what we think they're worth. So I don't think it would take much of a correction to produce some great buying opportunities among stodgy blue chips, but I think tech stocks, for example, would need to fall a long way before I would find them attractive.

Q: Pat, you just came out with a book, The Five Rules for Successful Stock Investing. What are those rules?

A:

They are really pretty basic, because investing at its core is not about being complicated. The first is to always do your homework and thoroughly understand the stocks you buy. The second is to find economic moats, which are the characteristics that separate wonderful companies like Coca-Cola (KO ) and eBay (EBAY ) from the mediocre majority. The third is to always have a margin of safety -- which means buying stocks for less than you think they're worth.

The fourth is to always hold for the long haul, because future returns are uncertain, but taxes and commissions are very certain. If you pay less in taxes and commissions, you increase your odds of doing well against the market. Finally, you have to know when to sell, because although it would be great if we could all hold our investments forever, few companies stay great forever, and few investors are savvy enough to pick those that do stay great forever.

Q: What book would you recommend for the novice at stock investing who wants to start out right? Besides yours!

A:

If you don't know anything at all about investing, I think that there's a book by Andrew Tobias called The Only Investing Guide You'll Ever Need, which is a great introduction for the complete novice. If you're a little more sophisticated, I'd highly recommend Phil Fisher's Common Stocks and Uncommon Profits, and, of course, the annual shareholder letters for Berkshire Hathaway (BRK.Aand BRK.B ) by Warren Buffett are a fantastic resource -- best of all, they're free. Finally, I'll make a shameless plug for the book I just wrote, The Five Rules for Successful Stock Investing.

Q: How do you feel about tech? Your top five picks for 2004 in technology?

A:

I think the vast majority of technology stocks are horribly overvalued right now, which is probably not what you wanted to hear. So, to my mind, the outlook for tech stocks is pretty dim. As such, you might guess that I don't have too many tech picks, and you'd be right.

One interesting idea is Barra (BARZ ), which sells risk-management software to large money-management firms. The stock is trading at around $32, $10 of which is cash. It's a wonderful little company that dominates its niche and that I think has been overlooked.

Q: Is there a maximum price-earnings multiple that you consider for purchasing a stock?

A:

Not really, since the "right" p-e ratio depends greatly on the quality of the business. Personally, I've never bought a stock trading for more than 40 times earnings, but you sometimes see wide-moat stocks like Paychex (PAYX ) that never get cheaper than, say, 30 times earnings.

Q: You mentioned one of your rules was "find an economic moat." What does this mean?

A:

Economic moat is another way of saying competitive advantage. And a competitive advantage is simply a characteristic of a company that lets it make more money than a competitor. For example, Dell (DELL ) makes more money selling PCs than any competitor because of its direct sales and extremely tight inventory-management system. Those are Dell's economic moats.

Your own bank probably has an economic moat because it's a pain for you to switch checking accounts. In theory, since a bank is a bank, people would switch bank accounts frequently to get lower fees and higher interest rates. However, most banks retain 90% of their customers each year because it's simply a big hassle to switch banks.

Q: How do you know when to sell a stock?

A:

Well, the first thing to do is to always watch the company and not the stock. Stocks can move up and down for all kinds of reasons that have nothing to do with the value of the business itself. I'd say the five main reasons to sell a stock are:

1) You made a mistake and simply missed something when you first evaluated the company.

2) The fundamentals have deteriorated and the company you owned is simply not the company you bought.

3) The stock has simply gotten too expensive.

4) There's something better you can do with the money, since there's no shame in selling a stock with limited appreciation potential to purchase one with more upside.

5) The best reason of all to sell is if you have too much money in one stock. Although this means you're right and you should pat yourself on the back, you're courting too much risk if you let one stock become more than 10% to 15% of your portfolio.

Q: What's your feeling about energy stocks at this time?

A:

Typically, energy is a tough area to make a buck in over the long haul, because the price of oil is so cyclical. For investors who don't want to try to time commodity prices, I would suggest looking at pipeline companies, which tend to have very stable cash flow, strong competitive positions, and high yields. One that we like right now is called TransCanada PipeLines (TRP ), which owns the main natural gas pipeline between Alberta and the U.S. Northeast.

Q: Are drug stocks risky for the long term, with the cost of drugs a heated issue?

A:

That's a very good question, and I certainly think investors should not expect the kind of lovely gains from drug stocks over the next 10 years that we received in the past 10.

If you're looking at a drug company, I would stick with ones that have taken a less pugnacious approach to the issue, with Novartis (NVS ) being a good example. Merck (MRK ) also looks reasonably valued here. Given that many Big Pharma companies right now have a lot of single-product risk with big blockbusters coming off patent, you might be best off looking at an ETF [exchange-traded fund] that holds a basket of drug stocks.

Q: Is investing in emerging markets like India a good idea?

A:

Emerging markets do offer a lot of growth, but they also offer a lot of risk. You also have to remember that both India and China have run up significantly in the past year. Typically, the best time to put money into emerging markets is, in the words of Sir John Templeton, "when there's blood in the streets."

If you like the long-term prospects of India, or any other emerging market for that matter, then pick your stocks, do your homework, and wait for the political or economic scene to get ugly. That way, you'll have the confidence to buy when everyone else is selling. Corrections of 50% or more in emerging markets are not uncommon.

Q: Would Berkshire Hathaway likely be a good stock even if Warren Buffett were to die or get senile?

A:

Actually, it would be a better stock if one of those two unfortunate events came to pass, because many people would sell irrationally and drive the price down, which would make it more attractive to buy. I think Buffett has built a very solid foundation that will last for a considerable time after he's gone.

Right now, Berkshire is trading above our estimate of fair value. So I wouldn't be a buyer. Full disclosure: I do own some Berkshire shares, not the A shares.

Q: How much do you consider the debt-equity ratio in buying a stock?

A:

It's certainly worth looking at, because you want to be sure that a company has a firm financial foundation before buying the stock. In addition to the debt-equity ratio, you should also examine the footnotes to the 10K to see what kinds of cash commitments the firm has for the future. Sometimes, items like operating leases and loan guarantees don't show up in the debt-equity ratio, even though they represent very real claims on the company's cash flow.

Q: What's the best sector to be in in 2004?

A:

There's no particular sector that looks more attractive to me than others at the moment. In fact, I'm having a hard time finding buys. One interesting idea is title insurance companies, which typically have wide economic moats because of the difficulty of replicating a database of title records. Many of these stocks have great returns on capital and trade at single-digit p-e multiples.

We think they're cheap, even assuming a big falloff in the housing market this year. That said, they're not without risk since interest rates are extremely unpredictable, and a very sharp spike upward would cause the housing market to deteriorate faster than we're forecasting.

Q: How do you suggest investors do their homework?

A:

That's a great question. At a bare minimum, I would say reading the annual report to get a feel for the company's business model and management's character is a good idea. Even better would be to first read the 10K, which is more detailed than an annual report, and then review the past 10 years of the company's financial performance to see how consistent it has been. If this sounds daunting, don't worry. A lot of Web sites, including Morningstar.com, have 10 years of financial data available for free.

Q: Would you hazard a prediction for where the major indexes will be at the end of 2004?

A:

Actually, I won't. I think that trying to guess the indexes diverts your attention from what really matters, which is what your financial goals are and which stocks or funds are best to achieve them. I will say that anyone predicting the Nasdaq at 3000 has been smoking something. Tech stocks are, in general, an accident waiting to happen right now.

Edited by Jack Dierdorff

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