Stocks or the Market: What's Your Investment Policy? August 2003 - M.L.M. Do you depend on a rising market to make money? Or do you pick stocks that will appreciate through bull and bear times? Most managers follow the market. Warren Buffett picks stocks and ignores the market. The difference is investment policy. Either policy can work. A rising market does lift most stocks. And some good stocks will make money for you whether the market is rising or falling. On the other hand, investors can also be wrong with either policy. Studies show that no manager is consistently right about the market's direction over time. As for finding undervalued stocks, very few investors, professional or amateur, have been able to succeed like Buffett. How about your own approach? If you're a market player, your job is to forecast when the market will rise, or, what is just as tough, to hold on patiently if your forecast is premature. If your policy is to invest in undervalued stocks, your goal is to study a company so thoroughly that you discover strengths and promise in it that other investors have missed. You can make money with either policy, but you'll need to follow a few rules: 1) Decide whether you're more comfortable investing in the market or selecting companies -- and then stick with the policy you choose. A market investor has to go with the crowd; a stock picker moves against the crowd. It's difficult to do both well. 2) If you're a market investor, buy an index fund with low operating costs -- one-half percent, or 50 basis points -- and no sales charge. Funds based on the S&P500 index are widely available and cover the market well. 3) As a market investor, don't feel you have to "stay invested." No pundit or advisor guarantees that you'll make more money in stocks than in bonds, even over the next 10 or 20 years. I believe the stock market is too high today. The price/earnings multiple on the S&P500 is 33 (on August 18). That's more than twice its 60-year average. I'd wait until the P/E comes down below 20 to buy the market. (See "Only At the Right Price: P/Es, Dividends, and Value Investing.") Still, the crowd may push the market even higher than it is today. You have to make the decision for yourself. 4) If your policy is to be a stock picker, don't try to compete with Buffett, or with anyone else. You should be independent and hard-working, and you have to use good business sense. Rest assured that with persistence you will be able to find a good stock that others have missed. Market professionals -- brokers, analysts, and managers -- miss a lot. They are as driven by crowd psychology as any investor. What's more, they have complex business goals that affect both the stocks they look at and what they say about them. 5) If you think you've identified an undervalued stock, here is a checklist of questions that will help you make sure: a) Do you thoroughly understand the company's position in its industry and its competitive strengths? b) Can you make sense of the company's financial reports, including the footnotes? c) Is the company profitable and financially secure? d) Have you read past annual reports? Do they show that the company laid out a business plan and followed it, and has the company succeeded in the intended way? Does the current business plan make sense to you? e) Has the company's current management been in place for some time? Is it likely to remain? If you can honestly and objectively answer yes to these questions, and if you have reason to believe that other investors are ignoring the company's strengths, you may well have found an undervalued stock to own. But remember, most investors aren't buying the stock at the price it's trading today. That's why you can buy it below its real value. Back to MLM Commentary