Thursday, May 1, 2008

CREATING A PERSONAL MICRO MUTUAL FUND

The key to creating wealth, with the ultimate purpose to live off your investments, is to achieve far better returns from stock than the S&P500 without a corresponding increase in risk. This might seem obvious but we live in culture of extreme risk taking that has blurred the distinction between investment and speculation so much that high risk stock speculations have become the norm for many individual stock investors.

Gambling and speculation are characterized by taking large risks of a total loss in return for the low potential of a very large gain. Investing is really the opposite; it is finding the lowest risk of any loss with the most likely outcome of a modest gain or better. The central focus in investing is finding the lowest risk stocks with the best odds of outperforming the market. It certainly is not as exciting as a night in the casino but it is easy to sleep at night.

Let’s look at two different companies, one that we consider a high risk speculation and another with very low risk of a total loss and a good chance of outperforming the market over the next few years.

The first company, GBRC has a market cap of $105M and share price of $3.05. They have $780,000 in the bank and have never made any revenue or had a sale of any kind. Their return on equity is -744%. They are developing technology to decompose petroleum related products (like used tires). Hopefully they will make the technology work and be a fantastic financial success but the risks of a complete loss look too high for us. I am sure that the person that recommended this stock feels that they have some good insight into the likelihood of the technology working and are expecting a great result for it. But getting an exotic technology to work is only the first step; there must also be an adequate market size and an excellent management team to take advantage of the opportunity.

Contrast this with another company, Range Resources Company (RRC), which has a market cap of $9.81B and a share price of $65.45. They have $4M in the bank, a revenue stream of $868M/year, net profits of $166M/year, and they pay a quarterly dividend of 4 cents a share. Their last quarterly earnings were up 59.50%. RRC is an independent natural gas producer with properties in Appalachia and the Gulf coast with 5100 miles of gas gathering pipe lines that are delivered to interstate pipe lines which deliver the gas to utilities and large industrial consumers. Last year they increased their new reserves of natural gas for future production by 27%. The risk of the company going out of business and our stock becoming worthless are very low and the upside for reasonable profit and growth is high. RRC is an investment that we have included in our portfolio, and we never lose sleep over it. We have no doubt that people will continue to need natural gas for heat and electricity.

As good as RRC looks to us and as good as the natural gas industry as a whole looks, we still put only a small percentage (2%) of our portfolio in this stock and only 6% of our portfolio into the overall natural gas industry. This is our way of reducing the risk of loss of our capitol by having a highly diversified portfolio. We do not invest more than 2% of our portfolio in any given company no matter how compelling the company looks. It is far safer to have 50 very amazing companies across all industries than to have all of our assets in a few companies or in a few sectors of the market. This also allows us to focus on the quality of the company instead of the latest buzz about a particular sector. We find the best companies to invest in are the better run companies in sectors that are out of favor with investors.

I have met with mutual fund managers that strongly object to people like us investing this way. They say that they can invest better than an individual and that the trading fees are prohibitive for the individual to make it work. We feel that mutual funds have proven the value of this method of investing, especially for individual investors with the time, interest and aptitude. We have also found that being able to control the timing of when we take profits and losses to maximize our tax benefit far outweighs the cost of our broker fees, and we use a full service broker! We think that it is far more profitable to run our own micro mutual fund instead of giving up profits to the managers in the form of outrageous salaries and bonuses.

Our investing approach has led us to own a large collection of unexciting stocks of stalwart companies selling products such as soap and toothpaste (CHD), pumps and motors (SHS), aerospace components (PCP, COL), pipes (SYNL), utility poles (VMI), natural gas (RRC, EGN), and welding equipment (LECO) Though the potential for an out of scale return may be very low, our portfolio is stable and growing at a reasonable rate (16% to 32%) every year. Most of our portfolio companies pay a dividend, giving us additional tax advantaged income. We have never lost sleep over any of our stocks nor felt the need to check on them constantly in fear that some catastrophe will occur that will wipe us out. We check on their status once a week to verify that they are on track and no major changes have occurred. If we get really upset at the management team, like we did at MCO last year, we sell them off. If the management team makes a move we like, as did the RRC team with their willingness to step out and acquire more natural gas properties long before the oil crisis came into view, we buy more.

We avoid investing in overseas stocks as they have no SEC oversight and no way for us to validate their accounting. We also feel that foreign based companies have much greater risks than US based companies due to the many uncertainties of foreign governments and currencies. We gain access to the growth in overseas markets through US companies that own operations and sell to customer bases overseas.

We have found that focusing on lowering the risks of our investment portfolio and finding the best values in well managed companies, rather than focusing on the huge potential upside of high risk speculative stocks serves us well. It has allowed us to create a portfolio of stable yet steadily growing stocks at a time when the stock market has had unprecedented instability and many mutual funds are struggling.

By moving to Hilo, Hawaii we have dramatically reduced our cost of living so that we can live without touching our stock portfolio allowing it to maximize its growth. At a rate of 20% a year, we will have more than doubled the portfolio value in 5 years, a reasonable gain for minimal risk, allowing us to stay as long as we want in this wonderful paradise of Hawaii.

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