The Five Rules for Successful Stock Investing: Morningstar's Guide to Building Wealth and Winning in the Market

by Pat Dorsey

You need to read widely to build a “latticework of mental models,” as Berkshire Hathaway’s Charlie Munger says. By looking closely at many companies, you’ll see common themes that drive their success or failure. And you’ll begin to form models that you can apply to situations you want to analyze. Then you must ask some questions. How is the world changing? How will those changes affect this company’s prospects? You can begin to see the challenge and the fun of investing.

The Five Rules for Successful Stock Investing: Morningstar’s Guide to Building Wealth and Winning in the Market is the effort of Pat Dorsey, the head of equity research at Morningstar.

SUCCESSFUL INVESTING IS simple, but it’s not easy.

Picking individual stocks requires hard work, discipline, and an investment of time (as well as money).

That’s the bad news. The good news is that the basic principles of successful stock-picking aren’t difficult to understand, and the tools for finding great stocks are available to everyone at a very low cost—you don’t need expensive software or high-priced advice to do well in the stock market. All you need are patience, an understanding of accounting and competitive strategy, and a healthy dose of skepticism. None of these is out of the average person’s grasp.

The basic investment process is simple: Analyze the company and value the stock.

If you avoid the mistake of confusing a great company with a great investment—and the two can be very different—you’ll already be ahead of many of your investing peers. (Think of Cisco at 100 times earnings in 20...

Your goal as an investor should be to find wonderful businesses and purchase them at reasonable prices.

Great companies create wealth, and as the value of the business grows, so should the stock price in time.

over the long haul, stock prices tend to track the value of the business.

Company fundamentals have a direct effect on share prices.

Instead, they all focus on finding undervalued stocks that can be held for an extended time.

Finally, successful stock-picking means having the courage to take a stance that’s different from the crowd.

Thus, as an investor, you have to be able to develop your own opinion about the value of a stock, and you should change that value only if the facts warrant doing so—not because you read a negative news article

First, you need to develop an investment philosophy, which I’ll discuss in Chapter 1. Successful investing is built on five core principles: 1. Doing your homework

2. Finding companies with strong competitive advantages (or economic moats) 3. Having a margin of safety 4. Holding for the long term 5. Knowing when to sell

Second, I’ll take a step back and review what not to do—because avoiding mistakes is the most profitable strategy of all. In Chapter 2, I’ll go over the most common mistakes that investors make. If you steer clear of these, you’ll start out ahead of the pack.

Find Economic Moats What separates a bad company from a good one? Or a good company from a great one? In large part, it’s the size of the economic moat a company builds around itself. The term economic moat is used to describe a firm’s competitive advantage—in the same way that a moat kept invaders of medieval castles at bay, an economic moat keeps competitors from attacking a firm’s profits.

Economic moats allow a relatively small number of companies to retain above-average levels of profitability for many years, and these companies are often the most superior long-term investments. Longer periods of excess profitability lead, on average, to better long-term stock performance.

The key to identifying wide economic moats can be found in the answer to a deceptively simple question: How does a company manage to keep competitors at bay and earn consistently fat profits? If you can answer this, you’ve found the source of the firm’s economic moat.

Finding great companies is only half of the investment process—the other half is assessing what the company is worth.

The goal of any investor should be to buy stocks for less than they’re really worth.

the future has a nasty way of turning out worse than

We can compensate for this all-too-human tendency by buying stocks only when they’re trading for substantially less than our estimate of what they’re worth. This difference between the market’s pri...

Always include a margin of safety into the price you’re willing to pay for a stock. If

For example, a 20 percent margin of safety would be appropriate for a stable firm such as Wal-Mart, but you’d want a substantially larger one for a firm such as Abercrombie & Fitch, which is driven by the whims of teen fashion.

and if you wait long enough, most stocks will sell at a decent discount to their fair value at one time or another.

To justify paying today’s price, you have to be plenty confident that the company’s outlook is better today than it was over the past 10 years. Occasionally, this is the case, but most of the time when a company’s valuation is significantly higher now than in the past, watch out. The market is probably overestimating growth prospects, and you’ll likely be left with a stock that underperforms the market over the coming years.

The real-world costs of taxes and commissions can take a big bite out of your portfolio. Extending your average holding period from six months to five years yields about $62,000 in extra investment returns. Lucy gets a lavish reward for her patience, don’t you think?

The key is to constantly monitor the companies you own, rather than the stocks you own. It’s far better to spend some time keeping up on the news surrounding your companies and the industries in which they function than it is to look at the stock price 20 times a day. Before I discuss when you should sell a stock, I ought to point out when you shouldn’t sell. The Stock Has Dropped By themselves, share-price movements convey no useful information, especially because prices can move in all sorts of directions in the short term for completely unfathomable reasons. The long-run performance of stocks is largely based on the

expected future cash flows of the companies attached to them—it has very little to do with what the stock did over the past week or month. Always keep in mind that it doesn’t matter what a stock has done since you bought it. There’s nothing you can do to change the past, and the market cares not one whit whether you’ve made or lost money on the stock. Other market participants—the folks setting the price of the stock—are looking to the future, and that’s exactly what you should do when you’re deciding whether to sell a stock.

that are up substantially to drop, just as there’s no reason for stocks that have tanked to “have to come back eventually.” Most of us would be better investors if we could just block out all those graphs of past stock performance because they convey no useful information about the future. So when should you sell? Run through these five questions whenever you think about selling a stock, and you’ll be in good shape.

Did You Make a Mistake? Did you miss something when you first evaluated the company? Perhaps you thought management would be able to pull off a turnaround, but the task turned out to be bigger than you (and they) thought. Or maybe you underestimated the strength

No matter what the flub, it’s rarely worth holding on to a stock that you bought for a reason that’s no longer valid. If your initial analysis was wrong, cut y...

Have the Fundamentals Deteriorated? After several years of success, that raging growth company you bought has started to slow down. Cash is piling up as the company has a tougher time finding profitable, new investment opportunities, and competition is eating away at the company’s margins. Sounds like it’s time to reassess the company’s ...

Is There Something Better You Can Do with the Money? As an investor, you should always be seeking to allocate your money to the assets that are likely to generate the highest return relative to their risk. There’s no shame in selling a somewhat undervalued investment—even one on which you’ve lost money—to free up funds to buy a stock with better prospects. I did this myself in early 2003 when I noticed that Home Depot was looking awfully cheap. The stock had been sliding for almost three years, and I thought it was worth about 50 percent more than the market price at the time. I didn’t have much cash in my account, so I had to sell something if I wanted to buy Home Depot. After reviewing the stocks I owned, I sold some shares of Citigroup, even though they were trading for

Do You Have Too Much Money in One Stock? This is the best reason of all to sell because it means you did something right and picked

a winner. The key is to not let greed get in the way of smart portfolio management. If an investment is more than 10 percent to 15 percent of your portfolio, it’s time to think long and hard about trimming it down no matter how solid the company’s prospects may be. (These percentages are a rough guide—you might be comfortable with more money in a single stock, or you might want to be more diversified.) It simply doesn’t make sense to have too many of your eggs in one basket.

Investor’s Checklist: The Five Rules for Successful Stock Investing • Successful investing depends on personal discipline, not on whether the crowd agrees or disagrees with you. That’s why it’s crucial to have a solid, well-grounded

grounded investment philosophy. • Don’t buy a stock unless you understand the business inside and out. Taking the time to investigate a company before you buy the shares will help you avoid the biggest mistakes. • Focus on companies with wide economic moats that can help them fend off competitors. If you can identify why a company keeps competitors at bay and consistently generates above-average profits, you’ve identified the source of its economic moat. • Don’t buy a stock without a margin of safety. Sticking to a strict valuation discipline will help you avoid blowups and improve your investment performance. • The costs of frequent trading can be a huge drag on performance over time. Treat your stock buys like major purchases, and hold on to them for the long term.

Know when to sell. Don’t sell just because the price has gone up or down, but give it some serious thought if one of the following things has happened: You made a mistake buying it in the first place, the fundamentals have deteriorated, the stock has risen well above its intrinsic value, you c...

Seven Mistakes to Avoid

1. Swinging for the fences

2. Believing that it’s different this time 3. Falling in love with products 4. Panicking when the market is down 5. Trying to time the market 6. Ignoring valuation 7. Relying on earnings for the whole story

Swinging for the Fences This ties back to the importance of buying great companies with strong economic moats. Loading up your portfolio with risky, all-or-nothing stocks—in other words, swinging for the fences on every pitch—is a sure route to investment disaster. For one thing, the insidious math of investing means that making up large losses is a very difficult proposition—a stock that drops 50 percent needs to double just to break even.

When you look at a stock, ask yourself, “Is this an attractive business? Would I buy the whole company if I could?” If the answer is no, give the stock a pass—no matter how much you might like the firm’s products.

Stocks are generally more attractive when no one else wants to buy them, not when barbers are giving stock tips.

“The time of maximum pessimism is the best time to buy.”)

The only reason you should ever buy a stock is that you think the business is worth more than it’s selling for—not because you think a greater fool will pay more for the shares a few months down the road.

If the market’s expectations are low, there’s a much greater chance that the company you purchase will exceed them.