Portfolio Design: Building Bridges

The Art & Science of Portfolio Design

by Mark Robertson, Better Investing, August 2002

Building Bridges

“It still holds true that man is most uniquely human when he turns obstacles into opportunities.” — Eric Hoffer (1902-83), U.S. philosopher. Reflections on the Human Condition.

Portfolio design. Art or science? Or both? We build our portfolios with the expectation they’ll bridge to desired outcomes and financial independence. Perhaps visionary artist, scientist and Renaissance Man Leonardo da Vinci can inspire some insights on portfolio design?

The term renaissance literally means “rebirth” and was first used in 1855 by French historian Jules Michelet. The Renaissance was a period of intellectual revival, roughly from the 14th through the 16th century, and marked the transition from medieval to modern times. This period is regarded as a time of intellectual ferment that laid the foundation for future progress.

Some historians suggest the Renaissance was indeed the birth of modern humanity after a long period of decay. Modern scholars have since debunked the idea that the Middle Ages were dark and dormant.

Parallels to Our Current Stock Market?

The last two years have not been kind to investors. It’s a massive challenge to find solace in returns that haven’t receded as much as the market in general. Declines are still that — declines. In some ways, the decline of the last two years has been more severe than what was experienced in 1973-74. Experienced investors often describe their 1970’s experience as a sort of investing dark ages. The high inflation rates and recessionary conditions must have seemed interminable at the time.

But [our community of] investors who have “been there” seem to focus on something completely different. During a recent presentation in Cleveland, a gentleman used our question-and-answer session to share how everything he did during the 1970s — a systematic implementation of buying good companies at good prices — was merely the launch pad for what happened in the 1980s and 1990s. Thomas O’Hara speaks of the period in the same tone of voice and same life experience.

Some would have us believe we’re at the doorstep of another dark age. The last two years are their evidence. I believe the renaissance of American enterprise that ignited during the 1980s and caught fire during the 1990s is merely pausing to catch its breath.

Unleashing Leonardo — 500 Years Later

In 1502 da Vinci proposed building one of the largest bridges in the world for the ruler of the Ottoman Empire.The Sultan wished to span the Golden Horn, an inlet between the Turkish cities of Pera and today’s city of Istanbul. To the astonishment of the Ottoman court, the proposed design took the form of a giant arch. After conferring with advisers, the sultan responded with what seemed like commonsense — an arch that big would collapse in the middle. He declined the proposal.

In his book, How to Think Like Leonardo da Vinci, Michael J. Gelb shares his perspective on seven principles drawn from a study of the man and his methods. The first principle is Curiosita — an insatiably curious approach to life and an unrelenting quest for continuous learning.

Portfolio Design

The elements of portfolio design are the continuous selection (and accumulation) of quality companies and the continuous development of expected returns for the holdings that serve as our bridges. Be continuously curious.

Building Castles of Sand

Building Castles of Sand in The Great Valley

Something To Believe In (REPRINTED FROM BETTER INVESTING, OCTOBER 2002)

by Mark Robertson, Senior Contributing Editor

Few things are more contagious than emotions. One of our biggest challenges is to prevent emotions from clouding long-term perspectives. I believe that core fundamental growth and profitability is intact and that the assumptions and judgments that we make during our stock studies do not require massive adjustment. Long-term growth expectations may be slightly subdued but the impact probably isn’t all that material. If you believe as I do, then it follows naturally that some excellent companies are available at reasonable prices.

The events of a certain bright September morning brought us to our knees. Those memories will never leave us.

Our awareness of the passage of time was, at least temporarily, altered. Where days were once blurs and years and decades somewhat-defined horizons, instead the long term became blurred. In sharp contrast, the daily images burst forth in crystal clarity. Fear took on a precise nature.

The damage became even more pervasive as an already weakened economy mightily struggled to regain its balance. The effort proved futile. First one, then another supposed paragon was exposed. Confidence was breached. Fiduciary faith is one of the more fragile varieties. Only the passage of time combined with an uninterrupted demonstration of credibility and reason will restore consumer confidence to necessary levels.

Trust is still the biggest component of any P/E ratio.

Our National [Convention] and Bricks

Better Investing for Better Living.

Our theme is timeless and in many ways, immune to the challenges of this past year — so long as the long-term perspective is maintained.

NAIC co-founder and Chairman Emeritus Thomas O’Hara reminds us: “Times like these are when it is most challenging to capture the attention of would-be investors.” The distraction of a bear market is unfortunate. These times are also the best time to start (or augment) a lifetime program of strategic long-term investing.

A friend once commented that during market breaks, it seemed like his best clients would throw bricks through his office window. He didn’t mind the shattered glass so much. (After all, we build castles from sand.) But what he really wishes is that they would tie a few dollars to the brick before launching it. Then he would be enabled to invest on their behalf — in excellent companies, at good prices — when it was easier to do so.

Faith and Castles of Sand

Can faith be restored? In the Disney movie, “Land Before Time,” the main character is an adolescent dinosaur named Little Foot. During a pilgrimage to a so-called Great Valley, a land of plentiful green plants and fresh bodies of water, Little Foot’s mother is injured while protecting the herd from predators. With her last breath, she points Little Foot in the right direction and urges him to lean on faith. When Little Foot asks his mother exactly what faith is, she provides one of the best definitions of faith I’ve ever heard: “Some things you see with your eyes. Faith is when you see things with your heart.”

The preservation of faith and corporate credibility is an overwhelming responsibility. The actions of a few have grievously undermined confidence. Cardiac vision has been blinded and the moral melee has become a maelstrom. Seeing every single corporate [data point] has never been what [our investing method] is all about and I hope it never will be. This circus will be over when an executive can talk to us without inhibition. That day will come.

We will indeed return to building castles by the sea with the knowledge that tides, erosive winds and castle-smashing vandals are a fact of life. Sand castles are naturally swept away. Sand-castle virtues are precious and deserve better respect.

Profitability Forecasting

 We collectively owe all Value Line analysts an apology. We’ll use this household products leader — and walking, talking and breathing Up, Straight & Parallel business analysis — to take a closer look at profitability forecasting.

Church & Dwight (CHD)

Church & Dwight Co., Inc. engages in the development, manufacture, and market of household, personal care and specialty products. It sells consumer products under a variety of brands through a broad distribution platform that includes supermarkets, mass merchandisers, wholesale clubs, drugstores, convenience stores, dollar, pet and other specialty stores and websites all of which sell the products to consumers. The firm focuses its marketing efforts on its brands, which includes ARM & HAMMER, TROJAN Condoms, XTRA laundry detergent, OXICLEAN pre-wash laundry additive, NAIR depilatories, FIRST RESPONSE home pregnancy and ovulation test kits, ORAJEL oral analgesics and SPINBRUSH battery-operated toothbrushes. It operates through the following segments: Consumer Domestic, Consumer International and Specialty Products. The Consumer Domestic segment includes the eight power brands and other household and personal care products such as SCRUB FREE, KABOOM and ORANGE GLO cleaning products, ANSWER home pregnancy and ovulation test kits, ARRID antiperspirant, CLOSE-UP and AIM toothpastes. The Consumer International segment primarily sells a variety of personal care products, some of which use the same brands as its domestic product lines in international markets. The Specialty Products segment produces sodium bicarbonate, which it sells together with other specialty inorganic chemicals for a variety of industrial, institutional, medical and food applications in U.S. The company was founded by Dwight John and Austin Church in 1846 and is headquartered in Ewing, NJ. [Source: Wall Street Journal]

 

I think we might owe the Value Line analysts an apology.

This might be one of those moments when we realize that something we’ve believed, shared and taught just doesn’t work out the way we expected.

I hate when moments like these happen.

The culprit is usually a Value Line company report. You know the ones I’m talking about. The companies that have been running close to a 5.0% net margin for the last few years and the Value Line analyst has a 3-5 year forecast of 7.5% for the projected net margin. We snicker. Some of us guffaw. Almost all of us discount the forecast.

It’s probably time for a deep breath. A few more moments with curved shower rod curtains while we tack the ends of the ham and restore it to Grandma’s oven. (See Cutting Off The Ends for more on this subject)

The Management Report Card: Profitability

The second part of an SSG-based stock analysis includes a look at profitability trends.

Faced with slide rules and abacus beads, George Nicholson resorted to a moving average for “instant trend analysis.” It’s very straightforward. A comparison of current conditions (higher or lower) versus the trailing 5-year average tells us whether recent results are above (good) or below (bad?) the longer term trend. There is nothing wrong with this convention.

But we use the Preferred Procedure — a business model analysis — to build the long term return forecast for the companies we study and analyze. And we’ve generally used the trailing 5-year average net margin as the projected profitability.

(1) This will build in some conservatism, and (2) we lean on the “excuse” that we’re doing the analysis for each and every company the same — so it’s all “relative.” This too is a decent, but flawed, convention. Even if it’s WRONG.

The problem is that we’re striving for better absolute forecasts.

“The moving average forecast is based on the assumption of a constant model.” — University of Texas, Statistics

 

Does anything about that accompanying chart of long-term aggregate net margin (1940-Present) look CONSTANT???

Church & Dwight (CHD): Profitability Trends. The actual and forecast net margins for CHD are shown in the profitability graphic on the left. The graphic on the right supports a comparison of actuals (red bars, 2009-2016) versus the forecasts (purple bars) based on 5-year trailing averages back at the time the forecasts were formed.

The fact that we have embedded analyst estimates for profitability for this year, next year and 3-5 years out (when available) for our long-term forecasts means that we are less impacted by this condition than what is depicted on the right.

Bottom Line

I think it’s clear that we’d want a forecast for CHD that is essentially between the VL 3-5 year forecast and the exponential regression shown on the left image. It’s probably also clear that for a profitability profile like the one on the left, the trailing average forecast is going to consistently produce a lagging forecast.

Remember the example of margin expansion by Coca-Cola over the years cited by Steve Sanborn. It’s simply a reality that profitability characteristics shape and evolve over the life cycle of all companies.

The moving average forecast method really only works (accurately) for mature stocks with relatively constant profit margins.

The problem is that there aren’t very many companies that fit this description. Our database includes a forecast algorithm that essentially smoothes and weights the more recent years. When we use this method for Church & Dwight, our 5 year net margin forecast aligns very closely with Value Line’s 3-5 year construct. We checked about (50) more companies — and those forecasts that we snickered and guffawed about — all checked out very closely.

We may owe the Value Line analysts an apology.

We will begin infusing this method with updates going forward until the entire database (at Manifest Investing) is converted.

Just Like Home …

This Expected Returns cover story from April 2009 underscores the things that really matter during bear markets, corrections and recessions.  We were reminded at the time to focus on high-quality opportunities with vigilance for upstart, promising companies ratcheted up.  If you’re curious about our work at Manifest Investing and the resources we provide for long-term investors, and interested in a FREE 90-day test drive, let me know via markr@manifestinvesting.com … for now, may your investing brackets be “nothing but net.”

The stock market madness of early March has given way to a rally that at least delivers welcome respite from the cascading decline we’ve experienced for several months.

Triple Play: A Measure of Opportunity. History suggests that the discovery of companies poised with Triple Play characteristics can lead to rewards. We’ve leaned on Nicholson’s Triple Play concept often since the 4th quarter of 2008, citing potential impact on our shopping efforts. Finding companies with the prospects of potential profit margin and P/E expansion seems prudent. Combining that potential with high-quality companies exhibiting out-sized PARs could deliver a measure of success and shining moments for our portfolios going forward.

 

March Madness now extends into April as the NCAA basketball championships bring the current season to a close. And the stock market madness of early March has given way to a rally that at least delivers welcome respite from the cascading decline we’ve experienced for several months. In the movie ‘Hoosiers’, there’s a classic scene where Gene Hackman, coach of the underdogs from a very small town, leads the boys into the championship venue for their pregame practice. He hands a tape measure to the anxious players and urges them to confirm that the hoop is 10 feet above the floor … just like home … and the free throw line, 15 feet … just like home.

From “Just Like Home” …

As many of you know, we’ve discovered that NAIC/BI co-founder, the late George Nicholson, focused his attention on “the next bull market” during the dreadful bear market of 1973-74. As we studied his writings at the time, we learned that he looked back to the lessons of the 1937-38 bear market — days when he was launching a successful career and lifetime of successful investing.

He believed that the challenges and opportunities of 1973-74 were similar to conditions last seen in 1937-38 complete with year-over-year 50% declines in automobile sales (sound familiar?) and a variety of economic ailments related to scarcity of commodities and mischievous behavior in the banking and investing sectors, etc. He developed a set of criteria — intended to seek opportunities just like “home.”

Although we can’t be certain, I can imagine that he saw it as a sort of antidote to the poisonous paralysis that afflicts so many of us as stock prices decline. In fact, Nicholson “pleaded” with investment clubs to commit to decisions during early 1975 — citing a recent 80% gain in Coca-Cola over a span of less than six months as evidence that prices could and often do, move in sudden spurts. (The stock price of Coca-Cola proceeded to languish for the next 5-6 years.) If you missed the autumn 1974 opportunity to own the Real Thing and waited a few months before committing, your experience was considerably less rewarding.

… to “Shining Moments”

CBS Sports features the song ‘One Shining Moment’ to encapsulate the highlight reel celebrating the coronation of this year’s champion.

Nicholson shared that some of the best shining moments of a lifetime of successful investing could be traced to the elements of his Triple Play concept. Here are the three features that qualify a stock for Triple Play status: (1) A depressed stock price. Think elevated projected returns. (2) A potential for P/E expansion over a 5-year time horizon and (3) A potential for profit margin expansion. Such stocks are most frequently found at the end of a long bear market.

“I have been investing in Triple Play situations during 1973-74 in preparation for the next bull market. If past performance is any guide, the performance should exceed [stock market returns] by a wide margin.” — George Nicholson.

Triple Play Candidates. This listing of study candidates was shared with the attendees at the Better Investing regional conference in Lansing, Michigan on April 3-4, 2009. Our database was screened for companies with PAR>21%; Quality>60; EPS Stability > 60; and Financial Strength > 70. A large number of companies are poised for P/E expansion (not shown) and the screening results shown here are sorted by annualized net profit margin (%) expansion in descending order. Note Solomon Select company, Mettler-Toledo, and the other precision instrument companies.

Bear Down, Regularly

There’s an insurance company commercial running on television where the celebrity sponsor (President Palmer for ‘24’ fans …) shares that we’ve been through twelve recessions over the last 50 years or so. All of them ended and a period of economic expansion ensued.

During a recent seminar, Steve Sanborn, retired director of research for Value Line, and I shared that — in his wealth of investing experience — all bear markets have ended. In that seminar, we explored the history of bear markets and underscored the similarities between 1938, 1974 and 2009 as supported by the accompanying graphic.

The lessons of history suggest that it’s probably time to think less about poisonous paralysis — avoid remaining unduly mired in yesterday’s quagmire — and focus a whole lot more on an effort to engage tomorrow’s prosperity. The table displays a listing of companies with depressed stock prices and the potential for profitability and P/E expansion. Many of these companies were mentioned multiple times by some pretty effective stockpickers and educators at the regional conference in Lansing, Michigan on April 3-4.

The list includes some community favorites, a few newcomers and a few Solomon Select legacy features.

Growth by Recession

It’s probably time for a reminder that our emphasis on focus on size diversification includes a healthy nudge. That nudge entails the continuous pursuit of companies with higher top line growth expectations. It also includes an increased focus or emphasis during periods when we may be approaching the end of a recession.

Bear Market Comparisons. As shown here, the bear markets of 1937-38, 1973-74 and 2007-2009 exhibit some similarities when compared versus all of the bear markets that have come and gone before. No, Virginia, we’re not seeing conditions like the Great Depression (see 1929-32) yet. Nicholson seized the moment in 1973-74, seeking Triple Play candidates to ready his portfolio for the next bull market.

 

You’ll hear some pundits, rhinos and talking heads continuing to encourage blue chip companies and we’ll nod and agree that this pursuit should be continuous, too.

That said, we also heed the advice of Peter Lynch. The Magellan maestro suggested that small companies can be more nimble and recover more quickly coming out of recessions. This reality is one of the things that leads to frustrating periods where blue chip languish while “garbage companies” seem to flourish. An investor over-concentrated in slow-growth blue chips last experienced this during the 2003 bull market.

Dial up shopping efforts and maintain overall portfolio sales growth at the high end of your comfort range. Languish a little less.

I have a small confession. Much like Jim Surowiecki, I’m sometimes conflicted with doubts about how much this “quality stuff” really matters. After writing The Wisdom of Crowds, Surowiecki shares several experiences where he doubted the wisdom of a gaggle of chefs in some “predictive kitchen” only to discover that the collective wisdom held up well … again, despite and in deference to any doubt.

And every time I check, I’m stunned by the reinforcement and rediscovery that comes with it.

2-Year Annualized Returns for Low-Quality Companies. The companies shown represent approximately (20) of the lowest quality ratings as of March 2007. The average annualized loss for this group of companies is 60%. Yes, 60% … and that doesn’t count three companies no longer “on the board” because they’ve gone bankrupt and no longer exist. In a word, Ouch.

The accompanying graphic is from a couple of slides presented at the regional conference — updating a look at bear market performance for low-quality companies versus high-quality companies. Yes, we’re talking about the current bear market.

And yes, the contrast is stunning. And it hits a little close to home as we watch companies like General Motors (GM) drop from $29.27 to $1.94 over a period of two years — an annualized loss of 74% (per year!)

Nicholson’s Legacy Continues

The companies shown in the accompanying graphic are often found on subscriber dashboards and rank among the most commonly-held and widely-followed by our Community. We’re proud, yet humbled, that companies like Solomon Select feature Strayer Education (STRA) tops these charts, compelling us to continue our quest.

2-Year Ann. Returns for Highest-Quality Companies. In sharp contrast, the highest-quality companies combined for an average return of -19% versus a stock market down -27%. Note that three companies (including a couple of community favorites and a Solomon Select alum) managed positive returns!

 

Nicholson strongly cautioned avoiding lower quality companies as bull markets raged. In our vernacular and interpretation, we’d translate that to: “periods where MIPAR is historically low” as our measure of bull market condition.

Where’s your “investing tape measure?” In the spirit of Hoosier coach Norman Dale (Gene Hackman), we continue to urge that seeking Triple Play Candidates and heeding the repeating lessons of Quality are pretty good yardsticks to honor.

Just like home … Indeed.

Invest Like Spock

Invest Like Spock

This morning, Forbes featured a column with the comment:

“Invest Like Mr. Spock . Okay, so I’m a trekkie. I like Mr. Spock’s ability to be human, yet make big decisions based on rationality.” — John Wasik

This nudges fond memories of a Round Table discussion by Hugh McManus (February 2011) that covers investing psychology and avoiding ending up on the wrong end of a spear as a happy resident in a Vulcan retirement home.

https://www.youtube.com/watch?v=LScAky5IhjM&t=947s

From “fat” as the “perfect food” to campfires at night, taking turns sleeping, to hunting in packs … to recognizing that investment disruptions are rarely fatal … to maintaining a true long-term perspective — with your Friends.

Five Smooth Stones


Invest regularly in high-quality companies when they’re on sale. Prudently diversify. It’s a little like going to battle armed with five carefully selected smooth stones and a steadfast long-term perspective. — Manifest Investing Newsletter (June 2012)

The biblical story of David vs. Goliath is fairly widely known. Many would consider it among their favorite stories as a child. After declining the king’s body plate and armor, shepherd David proceeds to a stream and selects five smooth stones. Why five? Well, first and foremost, that was his divine guidance. But another potential driver is not as well known (and sometimes disputed.) Answer: Goliath had four brothers. Form your own conclusions. We prefer to think of this as extreme planning. And in days when market predators seem to ravage our flocks of stocks with abandon, it’s comforting to think about longer perspectives and five smooth stones with masterful sling shot prowess. Bear markets, even gigantic ones, are brought to their knees with the right perspective.

With Tin Cup sinking below $900,000 after our recent million-dollar moment, we’re reminded — starkly — that “Stock prices fluctuate.” Should we have increased cash equivalents for Tin Cup based on some elusive indicator during the first quarter? No. As a policy measure, Tin Cup is committed to remaining fully invested in equities 100% of the time. This necessarily means that we’ll endure roller coasters.

In the aftermath of a month like May 2012, many investors within this community long for the messages delivered by the late Louis Rukeyser. Lou’s steady and calming Wall Street Week (WSW) messages were a staple several years ago on PBS. Hugh McManus shared a number of YouTube rebroadcasts of these messages. Among our favorites include the October 1987 show where Mr. Rukeyser reminded investors worldwide to stay focused on what really matters — family, friends — and discouraged any thought of kicking the family dog or dining room furniture.

We happen to believe that high-quality excellent companies purchased/accumulated with elevated return forecasts means that the roller coasters will be of the kinder, gentler variety … but some turbulence is unavoidable.

We wrote extensively of the carnage endured by Tin Cup during the Great Recession (2008-2009) and didn’t waiver in our expectations that “everything will ultimately be all right.” We fully acknowledge that this whole scenario can be different depending on your age/time horizon, risk tolerance, attainment of critical mass, etc. But we also think — for some — avoiding the challenge of making asset allocation adjustments is also quite desirable. In fact, we can point to several successful long-term investors who refuse to spell asset allocation or worry about any form of tactical decisions along the way (outside of carefully pursuing growth/size diversification.)

Benjamin Franklin and Albert Einstein are two individuals often attributed with the following worn-out expression:

“The definition of insanity is doing the same thing over and over again while expecting different results.”

In a commentary by O’Reilly’s George Alistair Sanger, he points out:

(1) The saying isn’t true.

(2) It isn’t the definition of insanity, instability or even pimples.

(3) It could actually be harmful advice.

(4) It contradicts the notions of experiment and practice.

(5) It does not make up for being harmful and wrong by being particularly funny.

(6) It is not documented to have originated from either Franklin or Einstein.

Invest Long and Prosper

On these pages a little over a year ago (March 2011) Hugh McManus shared some thoughts on fear, primal instincts and linked his conclusions to Star Trek. That’s right. Hugh urged us to invest like Spock not like Captain Kirk. Fear is powerful and can trigger emotions that cloud our long-term judgment.

Hugh admitted during a recent discussion that he actually hoped for a sluggish stock market — some would say “lost decade”, starting in approximately 2000. Is there method to his madness? Absolutely. But you have to account for his age and position on the spectrum of peak-compensation years, etc. In his view, the last several years have been an opportunity to accumulate stocks like Solomon Select feature Walgreen (WAG) at multi-year low prices.

Our discussion rekindled memories and thoughts of the 1970s and the stocks featured by Better Investing magazine during the teeth of the oil embargo and misery index days. Some of the best-performing stocks were chosen during those dark days — a reality that we’ve not fully capitalized on. Are the present conditions and doldrums an opportunity for history to repeat?

As a case in point, The Limited (LTD) was selected by Better Investing in 1982 just in time for the secular bull market. The story was solid — centered on the steadily increasing number of women in workplace and apparel market drivers. The Limited has been one of the absolute best performing stocks over the last several decades, delivering 17% (+7.3% relative return) from 1982-2012.

Hugh does an excellent job of separating emotion from investing and sticks to excellent companies or special situations with long-term merit. He’ll sometimes dabble with a turnaround or emerging company if he perceives opportunity and effective leadership. His perspective extends from at least five years to decades.

Long-Term Performance Profiling. Mapping the relative return results of a variety of club-based portfolios (dark blue dots) and MANIFEST portfolios (light blue) versus a relatively random sampling of institutional portfolios (red dots) presents a compelling story. From Peter Lynch’s Magellan track record at the top to DALBAR’s recent findings of -5.3% relative returns experienced by “average investors” from 1991-2010, the influences are intriguing. We really do believe that groups of investors who heed the lessons of Nicholson, Babson & Graham have at least one leg up on the crowd.

Portfolio Stewardship

In a recent article for US New & World Report David Armstrong asks: “As an investor, have you taken stock of your personal behavior as it relates to the stewardship of your portfolio? If you haven’t, let me tell you it matters—a lot.”

“It’s well documented that investment success is linked in part to behavior. Some investors continue to make the same mistake over and over again: They buy high in the face of euphoria and sell low in the face of fear.”

“In fact, I suspect such behavior has a lot to do with the horrible returns the average investor has achieved from 1991 to 2010 as reported by a recent DALBAR study. It is a pitiful 2.6 percent annual return.”

At 2.6% over that time frame, the relative return achieved by “average investors” according to the DALBAR study is -5.3%. Chase hot stock tips and buy high, sell low. It’s the only way to get “there.”

Checking Emotion At The Door

We believe that the analysis techniques and portfolio design & management methods of the modern investment club movement offer significant potential. Refer to the accompanying graphic of group averages. Although we should consider the preliminary results to be a work-in-progress, similar to a small percentage of “precincts reporting”, the average results of the club-influenced portfolios are outperforming their institutional counterparts. We should note that — if anything — there’s a positive bias for the rhino funds, because we included the most successful and widely-held in our early sampling efforts.

We know the drill. Invest regularly in high-quality companies when they’re on sale. Prudently diversify. It’s a little like going to battle armed with five carefully selected smooth stones and a steadfast long-term perspective. Sling at will. Invest long and prosper.

the Sage of Madison Heights

In honor of this week’s BI National Convention, here’s a lengthy (but representative) Smart Money article about NAIC, investment clubs and Tom O’Hara. Smart Money is “extinct” and reprints of the January 1999 issue are scarce. The article is presented here, largely in its entirety, with a few edits for accuracy. I collaborated with the author, Emily Harrison Ginsburg, and was influential in the development of the story as she explored the organization and the investment club movement. First and foremost, Tom thought the article focused too much on him. Some of the achievements and contributions of the likes of George Nicholson, Ken Janke and a nation of volunteers were less obvious. But the facts are facts. O’Hara was chairman of the organization for more than 50 years. How many people — ever — have been able to say that? It’s also a fact that Tom paid his $20 monthly dues to the Mutual Club of Detroit every single month since February 1948. I watched him withdraw several hundred thousand dollars and still have a balance greater than $1,000,000 in the club. His account had an annualized total return of 13.4% from 1948-2004, beating the stock market by more than three percentage points. The San Jose convention was huge and featured the Motley Fools and a keynote by Fidelity Magellan’s Peter Lynch among other noted investors. Nicholson referred to the modern investment club movement as a “Grand Experiment.” O’Hara thought of his massive community as the world’s largest and most successful investment club. — Mark Robertson

It’s a full house in the main exhibit hall at the San Jose Convention Center, with several thousand people brandishing large name tags and carrying white Lucent Technologies tote bags, each of them here for what looks like four days of nonstop talk about the stock market. “Did you see what small caps did this week?” asks one attendee. “Those Internet stocks are perking up again,” says another.

Amid the crowd roams am 82-year-old man dressed in pants that are a bit too short and accompanied by an attractive red-haired woman who hovers solicitously at his side, steering him gently by the elbow as he makes his way through the crowd. She occasionally whispers some comment into his ear and even slips him a mint at one point. As the elderly gentleman progresses on his trek, he says hello to many of his fellow conventioneers, his raspy voice barely audible above the din of the crowd, and stops to collect some of the giveaways being handed out by the investor relations people who are here in San Jose to pitch their companies’ stock to potential investors.

There is nothing particularly remarkable about this scene. In fact, this man, his wife of 47 years by his side, seems barely distinguishable from the thousands of others in the room. But then, suddenly, you notice that this elderly personage is being interviewed by a TV camera crew, that someone else is asking to have her picture taken with him (“This will be my keepsake,” she gushes), and that a large number of onlookers seem to be gazing adoringly as Thomas O’Hara makes his way past.

That’s right. Thomas O’Hara.

The name didn’t mean anything to you? Didn’t think so. But this gray-haired, soft-spoken man is a key reason there is nearly an overflow crowd at this California confab — the annual gathering of the National Association of Investors Corp, the umbrella organization for investment clubs throughout the country. That’s because in 1951, along with the same old Army buddies who lived near his suburban Detroit home, O’Hara formed the basis of the NAIC, an investing movement that over the years has transformed the country’s investing landscape, spawned the bestselling book, The Beardstown Ladies’ Common-Sense Investment Guide, grown into an organization of roughly 37,000 investment clubs and a total of [478,000 active participants] and turned O’Hara himself into one of the most influential people in the stock market.

Whether it’s through conventions like this one — which increasingly draw investor relations executives from public companies well aware that a favorable nod from the NAIC can attract plenty of new shareholders — or whether it’s through the NAIC’s monthly magazine, Better Investing which points out stocks for clubs to consider, or through the so-called I-Club-List, an Internet-based mailing list that generates some 100 emails/day, the NAIC’s reach is broad and powerful. Members invest about $1.3 billion in the stock market each year and now represent a cumulative stake of $175 billion. That chunk of assets would place the NAIC 21st in Institutional Investor magazine’s annual ranking of the country’s largest institutional investors, just above such meganames as American Express and Chase Manhattan. The NAIC’s key tenets are:

  • Invest on a regular basis.
  • Reinvest your earnings.
  • Buy growth stocks.
  • Diversify [prudently].

The guidelines are basic which members have embraced with an evangelical fervor. “Our only religion is that of the NAIC,” says Candis King, a 46-year-old mother of two from Chicago. And Thomas O’Hara is their touchstone, their messiah — the one who has shown them the promised land of double-digit annual returns.

Thomas O’Hara may be the messiah, but the drab one-story NAIC headquarters in Madison Heights, Michigan, is no mecca. An unrenovated elementary school is more like it. Inside, beyond the brown wood paneling and sea of cubicles are the unadorned, circa 1960s offices of O’Hara and Ken Janke, the 64-year-old president, who handles the day-to-day operations now that O’Hara has officially retired from the NAIC. (Unofficially, he’s still as involved as ever.)

Unassuming as it may seem, however, NAIC headquarters serves as Ground Zero for the investment club movement. For one thing, this is a clearinghouse for the 2 million brochures, books and magazines that the association sells every year. It’s also from here that the group’s flagship manual, Starting and Running a Profitable Investment Club, written by O’Hara and Janke, is distributed. The 250-page paperback has sold half a million copies since the team penned it three years ago, and it has been published in French. [And subsequently in Portuguese and Japanese also.]

The O’Hara Building, as it is called, is also the home of the NAIC stock-picking tools that thousands of members use to build their club portfolios. Take, for example, the Stock Selection Guide, or SSG, or “The Guide” — the very backbone of the organization. O’Hara, inspired by George Nicholson Jr. CFA, his club’s original broker, [embraced the two-page worksheet developed by Nicholson] that forces users to review all of a stock’s fundamentals, from price-to-earnings ratios to profit margins. Members then use the results of the studies to calculate whether or not a stock has the potential to double over the next five years — a most important NAIC general criterion. [In short, the “Guide” determines quality by peer/competitor comparisons and uses the return forecast to determine whether a given stock is “on sale.”]

NAIC advocates are so devoted to this system that the notion of a “hot” stock is anathema. In San Jose, one conference registrant could be overheard asking the woman at the registration desk, “You can’t give me any investment tips? That’s OK. We’re not allowed to take them anyway. It’s against the religion.” One club in Illinois earmarks only 10 percent of its assets to invest in non-NAIC sanctioned stocks, calling the stash its “Lunacy Fund.” Explains club founder Mark Robertson, a former engineer, local volunteer and now, senior contributing editor for Better Investing … “Anything outside of the organization’s principles [for core holdings] we regard as lunacy.”

If members are loyal to the SSG, they are obsessed with Better Investing magazine. The title has become a mantra. (A Better Investing banner flies alongside the American flag outside the headquarters.) “Best Wishes and Better Investing’ is the favorite email/correspondence signature of Mark Robertson.

At first glance it’s hard to see what all the fuss is about. A recent issue looks more like an accounting trade magazine than a stock picker’s bible. But NAIC members clamor every month for one feature in particular: “A Stock To Study.” The story — recently on men’s apparel maker Nautica Enterprises — is a five page treatise complete with charts, tables and a partially-completed SSG explaining why that particular stock is poised to grow.

But don’t call this a stock pick. Despite the fact that NAIC officers know that members end up not just studying but actually buying these stocks, they are adamant that nothing in Better Investing — or any NAIC publication or educational event for that matter — should be construed as a recommendation. “We are in the investment education business,” says Robert O’Hara, one of Thomas’ three children and an NAIC vice president. “Our goal is to try and teach people to do things for themselves.”

Whether or not the NAIC calls them picks, members are buying these stocks. Etana Finkler, for instance, a Rockville, Maryland computer-graphic artist, bought shares of Clayton Homes earlier this year at $16.50. What did she use to persuade her club to go along with the buy?

“When I presented the stock, I mentioned Better Investing has done three features on Clayton in the last three years,” says Finkler. (Clayton was down $1 at the end of November.) Eric Delph, who started a club four years ago in Huntington Beach, California, must have read those same articles. “I never would have heard of Clayton Homes if not for Better Investing magazine,” he says.

Janke himself provides what is perhaps the most telling evidence that a “Stock to Study” should really be called a “Stock to Buy.” Years ago [back in the 1950s], the NAIC ran a story on a bad stock. Plenty of clubs bought the stock anyway. “I guess people read the headline and didn’t really read on,” says Janke. As a result, every new stock featured in the magazine must now [meet the organization’s quality and buying metrics.]

Just who is setting those criteria and choosing those stocks? It’s not exactly a group of Wall Street-trained money managers, but it’s not a bunch of market neophytes either. O’Hara, Janke, Better Investing editor Donald Danko and seven other investment professionals (mostly chartered financial analysts) whom O’Hara and Janke have gotten to know over the years through various Detroit-based financial-industry functions make up what the NAIC calls the Securities Review and Editorial Advisory Committee.

The group meets over lunch each month to discuss stocks — not unlike an investment club. Each person comes prepared with a name or two and makes the case for nomination as a “Stock to Study” or “An Undervalued Stock.” When everyone has had their say, the company that will be featured is selected by voting.

As for performance, the stocks to study have done about as well as you would expect an investment club to do — some good periods, some bad. In the 42 rolling 5-year periods since 1952, Stocks to Study beat the Dow Jones Industrial Average 26 times. In the past five years, the raging bull market has run past the NAIC. Stocks that were picked in 1993 are up an average of 17.8% annually compared with 20.3% for the Dow. Plenty of clubs do better. Nancy Isaacs, a Toms River, New Jersey, member and NAIC volunteer, has watched her personal portfolio return 24% annually over the past five years. Through the NAIC, she says, “I feel empowered.”

Better Investing has another highlight members have learned to rely on: “The Top 100.” This annual list names the stocks most widely held by NAIC investment club members. Of course, just because clubs are buying a stock doesn’t necessarily mean it’s a good pick. But that doesn’t stop members from treating the list like a tip sheet. If other members are buying a stock, members figure, then it must have passed the NAIC criteria and therefore, [may] make sense for them. Don Heyrich, a 32-year-old attorney in Seattle, admits that his club uses the Top 100 as a source of new ideas, figuring other members have already applied the NAIC analysis and concluded that these were good stocks to own.

It’s no coincidence, then, that three of the top 10 names on the 1998 list — Intel, Lucent and Merck — are also among the 10 stocks most widely-held in Merrill Lynch brokerage accounts, a common gauge of how popular a stock is among individuals.

O’Hara has been preaching the gospel of individual investing ever since 1940, when he plunked down his first $20 monthly installment to join the Mutual Investment Club of Detroit. When World War II broke out, O’Hara started corresponding with members who had been drafted — first from his post in Iceland, then in London during the blitz. Military censors, who as a matter of course intercepted and read the group’s letters, started writing back asking how they could join the club. Within a year the Mutual Investment Club of Detroit had doubled in size. After the war, with three other clubs on board, the NAIC was born and Tom O’Hara was in charge.

By 1958, O’Hara quit his job as the director of the payroll department at the Detroit Board of Education to run the NAIC full time. A graduate of Wayne State University’s business school, with a degree in accounting, O’Hara has no other formal financial training — no chartered financial analyst designation after his name, no brokerage house experience, not even a stint as a financial planner. Nevertheless, his years of devotion to the individual investor have earned him a directorship at the Financial Analysts Society of Detroit and an advisory role on Securities and Exchange Commission committees.

O’Hara has spent the better part of the last two decades devising ways to bring more clubs into the fold. In 1979, for example, he started up the NAIC version of seed money for investment clubs, buying one share of a company’s stock, then selling that share to a member without a commission. That way a club could start small, access dividend reinvestment programs, and minimize expenses early in the life of the club.

It was about this time also that O’Hara made a shift in strategy that would fundamentally shape the future of the organization. With the stock market going nowhere, the phones weren’t exactly ringing off the hook. The modest club membership fees and publication sales couldn’t cover everything, so O’Hara and Janke began soliciting corporate sponsorship. Advertising discounts in Better Investing and the chance to tell their stories to investors through NAIC conventions were compelling to investor relations charged with reaching retail investors.

Throughout the 1980s, the NAIC slowly grew as clubs continued to catch on with investors. Then, starting in 1995, O’Hara’s homespun organization exploded with the publication of the Beardstown Ladies guide. The Beardstown Ladies were NAIC members and said so, loudly, in their book and appearances. Membership doubled from 1995 through 1998, thanks in part to the well-placed plug. Even when it became clear that the Ladies’ 23.4% annual returns were a mistake on the book’s cover — the impact did not spread to the NAIC. “There was no fallout,” says Janke. “We already had so much growth because of the booming market.”

O’Hara has obviously benefited from the investment club craze and bull market. Aside from his residence in Bloomfield Hills, the toney Detroit suburb close to Madison Heights, he owns homes in northern Michigan and Florida. A water buff, O’Hara owns a total of seven boats. As far as he’s concerned, the good times will go on. O’Hara remains relentlessly optimistic about the market despite the recent volatility. “The fundamentals of the market are better now than they have been for 20 years.” Of course, as the lead cheerleader for individual investors, you’d expect such a positive outlook.

Back at the San Jose convention, Andrew Backman knows how to work the NAIC crowd. The director of investor relations at Lucent is at a coffee shop down the street with a bunch of members whose clubs all own Lucent stock. The group is probably in their 50s with occupations ranging from housewife to lawyer, to engineer. And these investors aren’t playing with Monopoly money. The average member has a portfolio worth $223,000. [O’Hara also liked to remind that 14-of-15 investment club members would establish their own personal brokerage accounts for their “real money.”]

Lucent’s share price has recently dipped, and Backman is braced for the group’s reaction. “Are you concerned?” he asks. He’s pleasantly surprised by what he learns is a classic NAIC response. “No. We’re invested for the long haul,” one person pipes up. Some investors even volunteer that they have accumulated more shares at the lower prices.

What is Andrew Backman, a savvy corporate executive who is far more connected to Wall Street than he is to Main Street, doing at a coffee klatch of investment club groupies? Getting together with members, Backman says, is the best way to keep up with Lucent’s shareholders. “We can find out what their perspective is on the market, our sector and our stock,” he explains.

Backman isn’t the only corporate executive who has discovered the power of the NAIC. Don Eagon, head of investor relations at Diebold, has been currying favor with the organization and its members for years. Back in 1990, when Eagon first started with Diebold, he was alarmed at the large number of institutional owners — then as much as 86% — was causing unnecessary volatility in the company’s stock price. Eagon was concerned that two-thirds of the stock held by institutions was in the hands of only five firms. He set a goal to reduce institutional ownership to 75% of shares outstanding.

One of the first steps Eagon took towards achieving that goal? He joined the NAIC as a corporate member. “If you really want to build a strong base of individual shareholders, that is the way you do it,” Eagon says. He used his discounts to run at least six ads in Better Investing. And Eagon, or someone on his staff, began mingling with club members at several of the 75 regional investment education events, or fairs, that the organization sponsors every year.

All that was preparation for what he knew would really lure individuals — a spot on Better Investing’s Top 100 list. Once he hit that, Eagon must have known that Diebold would pull in even more individual shareholders. But what most corporate members really aspire to is being chosen as a BI Stock to Study. While joining the NAIC is no guarantee to a company that the securities review committee will feature it in the magazine, it does seem to help. 16 out of 36 stories highlighted once of the 280 member companies. [Only to the point of visibility and awareness, I can personally attest as a committee member that — if anything — corporate membership could actually inhibit the potential for a magazine appearance. — Mark Robertson]

Corporate membership paid off for Diebold with a place in the 1995 BI Top 100 and a [deserved] feature as a stock to study. Institutional ownership dropped to 73% that year and by 1999 was down to 54%.

But does corporate membership really serve NAIC members? While Diebold’s stock is certainly no dog — it has risen 19.4% annually over the last five years — it has lagged the S&P 500. Strict as the NAIC is about its stock selection criteria, the organization is far looser when it comes to screening corporate members. If a company is publicly traded, has been in business five years and is willing to pay the sponsorship dues, it’s in. “Our people are not stupid. We tell them to make up their own minds,” says Janke in defense of the program.

And, of course, devout members see no problem with the arrangement. “I have seen the NAIC principles work for me and my club,” says Cy Lynch, a 39-year-old Atlanta attorney. Anyone who is willing to spend the time can pick stocks as well as a professional money manager. I do better than my own mutual funds,” he says proudly.

One fall day, sitting in his office in Madison Heights, O’Hara was waxing sentimental about the displays of gratitude that members show him whenever he travels. “There is hardly a place we go that somebody doesn’t come up and thank us,” he says, the “we” meaning himself and his wife. “Three weeks ago in Chicago, a man came up and thanked me because he had saved and invested, and had a million dollars for retirement,” he says, slowly taking off his glasses to dab his eyes. A visitor, not noticing that the old man is actually wiping away tears, asks what it is like to have such an impact. O’Hara responds simply, “It’s a thrill.” And then, “Oh, look what you’ve done. You have gone and made me cry.”

  • Smart Money was the Wall Street Journal’s magazine of personal business. The finance magazine launched in 1992 by Hearst Corporation and Dow Jones & Company. In 2010, Hearst sold its stake to Dow Jones. The September 2012 edition was the last paper edition. Its content was merged into MarketWatch in 2013.
  • The institutional stake for Diebold (DBD) as a percent of float is now 96%.
  • Those 11 Best Stocks for 1999 from this issue were: Wells Fargo (WFC), Compaq, Kohl’s (KSS), DR Horton (DHI), Guidant, Warner-Lambert, Bank One, Apple (AAPL), Dollar General (DG), Toll Brothers (TOL) and Pfizer (PFE).
  • Warren Buffett and Berkshire Hathaway agreed regarding Clayton Homes, purchasing the company in 2003. One of our favorite — and most memorable — I-Club-List moments happened when Jim Clayton (Chairman and CEO) “showed up” to field some questions. We only asked him if he was really the Easter Bunny twice before realizing he was really Jim Clayton.