Swing Away with the Fat-Pitch Approach

Physician's Money Digest, April30 2004, Volume 11, Issue 8

To reach your goals, focus onabsolute, not relative, returns. Ifyou compare stocks and bonds,you'll find that stocks have abetter relative value. By converting nominalyields into real yields to show theexpected increase (or decrease) in purchasingpower over time among stocks,bonds, and cash, it's likely neither bondsnor stocks will do very well over the comingdecade because the yields on all threeare starting from a low level. Historically,10-year stock and bond returns have beenpretty bad when starting from a point intime when earnings yields and interestrates are very low.

This presents a big problem forphysician-investors who need higherreturns to reach their long-term financialgoals. This may include just abouteveryone except those who are in preservationmode with their assets–retireesor those close to it. For those with a fairlylong time horizon, the relative performanceof bonds vs stocks isn't what matters.All that matters is an increase inpurchasing power when the time comesto cash in your chips. So, what can youdo to solve this low-yield dilemma?

Fat-Pitch Approach

A possible solution to the low-yielddilemma is the fat-pitch approach tostock investing. This strategy can best beexplained using a baseball analogy.

In baseball, a batter who watchesthree pitches go past just inside thestrike zone will be called out by theumpire. Thus, baseball players oftenhave to swing at pitches they wouldrather not. Many physician-investorsare playing baseball when they invest.They fear being called out, so theyswing at pitches that they would ratherwatch go by. In other words, they forgettheir valuation discipline and think ofinvesting as a baseball game–threecalled strikes and you're out.

But what if the rules were different?What if a player could watch any numberof pitches go by, waiting for the perfectfat pitch to come along beforeswinging? Baseball will never adopt thisrule, of course–games would last toolong and players would routinely breakHugh Duffy's 1894 single-season battingaverage record. But remember thatyou, as an investor, can and should playby these rules. And no one can stop youfrom doing it.

This strategy has five parts:

1) Look for wide-moat companies.Companies with wide economic moats,such as Expeditors International, KinderMorgan, Iron Mountain, and Stericycle,reside in profitable industries and havelong-term structural advantages vs competitors.They're fat pitches with predictableearnings and long-term stayingpower. The odds are pretty high that overtime these companies will create shareholdervalue. By contrast, companieswith no economic moat generally destroyshareholder value over time–when youbuy one of them, you're making a speculativebet that the stock will bounce upjust long enough for you to sell it.

2) Always have a margin of safety.Instead of buying a stock based on whatothers are buying, buy a stock only whenit's selling at a decent margin of safety toyour estimate of its fair value. Don't eventhink about the overall direction of thestock market, because that's impossible topredict with any consistency. Think onlyabout individual wide-moat companies. Ifyou find one where the price is irrationallylow relative to its long-term intrinsicvalue, consider buying it–if not, hold off.

3) Don't be afraid to hold cash.Holding cash is like holding an option–the option to take advantage of volatility.The value of this option rises when marketvolatility rises. Many market participantsneglect this important aspect ofinvesting and stay fully invested at alltimes. When the market drops, they can'tdo anything but watch, or sell out nearthe bottom. Being fully invested goeshand-in-hand with a focus on relativereturns. Remember, we care only aboutabsolute returns, not relative returns.

4) Don't be afraid to make big bets.If you feel the need to hold more than 20stocks, you aren't using the fat-pitchapproach. In this case, you're speculatingand trying to diversify away the risk byholding lots of different names.

Of course, it's risky to hold a concentratedportfolio unless you abide by thefollowing three rules:

  • Only buy wide-moat companies.
  • Only buy these stocks at a signifi-cant discount to fair value.
  • Have a time horizon of at least 3years on each pick you make.

If you aren't willing to followthese three rules on each and every stockyou buy, then you need more diversificationin your portfolio.

5) Don't trade very often. If you'reusing the fat-pitch approach, you won'tneed to trade very often becauseyou'll hold only wide-moat companies.We rate these companies wide-moatbecause they have long-term advantagesand create shareholder value year in andyear out. Because they create value eachyear, their fair values tend to rise overtime. These are the only types of stocksfor which a buy-and-hold strategy workswell. As I said earlier, when you buy ano-moat stock, you're making a speculativebet that it will bounce up just longenough for you to sell it.

In essence, fair values are just an estimateof what a stock is worth under themost likely scenario for future earningsgrowth and profitability. Thus, there'salways less than a 100% probability thatyou'll be right about a stock pick. Giventhat the odds are below 100%, there's littlepoint in trading from one stock toanother frequently; your odds of beingright on the new pick are probably onlya little higher than the odds of beingwrong on the current pick.

Add to this the costs of trading–including taxes, bid-ask spreads, andcommissions–and the odds of generatinghigher returns by trading frequently areconsiderably worse than simply buyinggreat stocks at good prices and holdingthem for 3 years or more.

Tortoise and Hare Portfolios

MorningstarStockInvestor

Morningstar uses the fat-pitch strategyto manage the Tortoise and HarePortfolios. These portfolios consist of 10to 15 of our favorite wide-moat stocks.So far, the fat-pitch strategy is workinglike a charm. Since June 2001, whenwe rolled them out in , the Tortoise is up 40.7%,the Hare is up 2.2%, and the S&P 500is down 4.4%. Taken together as oneportfolio, the combined Tortoise andHare are up 21.6% over the past 2 1/2years. And with a beta of 0.88, the portfolioshave been 12% less volatile thanthe overall stock market.

Mark A. Sellers is equities strategist for Morningstar. He manages twoMorningstar portfolios and is the editor of Morningstar StockInvestor.To order a free trial issue, call 800-735-0700. He has played akey role in developing Morningstar's stock analysis methodology and proprietary measures. He iscurrently enrolled in the MBA program at the Kellogg School of Management at NorthwesternUniversity. He welcomes questions or comments at mark_sellers@morningstar.com, but cannot givepersonalized investment advice.