Apply These Successful Investment Rules

Physician's Money Digest

Investing in stocks is something of an art. To doit well, you'll need to know some of the tricks ofthe trade. Fortunately, was able to discuss stock tips with a financialartist from one of today's top investment researchfirms. Pat Dorsey is Morningstar's director of stockanalysis. In the following interview he shares his rulesfor achieving success in the stock market.

What are the five rules that physician-investorsshould always follow when investing in stocks?

First, always do your homework. Know the companiesthat you own inside and out. Next, find "economicmoats." Seek out firms with strong competitiveadvantages. Third, have a margin of safety. Alwaysseek to buy stocks at a discount to their intrinsicvalue. Fourth, don't trade frequently—the taxes andcommissions will eat you alive. Lastly, know when tosell—it's at least as important as knowing when tobuy, yet most people sell their winners too soon andhang on to their losers for too long.

What do you mean specifically when you refer toa company's "economic moat"?

An economic moat is what separates great companiesfrom the mediocre majority. It's another term fora firm's competitive advantage. Economic moats keepcompetitors from attacking a company's profits just asmoats kept invaders of medieval castles at bay. Askyourself how a company manages to fend off the competitionand consistently earn fat profits. If you canfind the answer to this deceptively simple question,you've found the source of a firm's economic moat.

In The Five Rules for Successful Stock Investing, youadvise potential investors to develop a rudimentaryunderstanding of accounting. Do people need to beCPAs to make informed stock decisions?

Not at all. A little accounting goes a long way, andbasic accounting is easier than it seems. If you can understandthe difference between cash flow and earnings,learn how to separate a shaky balance sheet from a solidone, and spot the warning signs of aggressive accounting,you'll be ahead of the pack. Accounting seems diffi-cult because financial statements use all kinds of unfamiliarjargon, but once you get past the strange-soundingwords, it's really not that hard. After all, accountingsimply shows how cash moves through a business, andthat can be surprisingly easy to understand.

Day trading became popular during the tech boom.Is it better for investors to sell stocks immediately whentheir value appreciates, or should they take a more longterminvestment approach?

Brokers may get rich from short-term trading, butinvestors won't. Trading often means paying taxes andcommissions, which, over time, could have compoundedand made even more money for the investor. The differencecan be staggering. At a 9% rate of return, $10,000grows to $31,000 if the portfolio is traded frequently, and$93,000 if traded infrequently. That's a big difference.

What are some of the more common mistakes investorsmake and how can they avoid them?

I think some of the most common are falling in lovewith products, trying to time the market, and panickingwhen the market is down. Many investors see the latestand greatest gadget and assume the company behind itmust be a wonderful investment. The reality is that therecan be a big gap between great products and great companies,and an even larger gap between great companiesand great investments. Trying to time the market is one ofthe all-time great myths of investing. It can't be done consistently,and anyone who says differently is probably sellinga market-timing service. Finally, panicking when themarket is down leads to poor investment returns becausestocks are more attractive when no one else wants to buythem, not when barbers are giving stock tips.

Advice from your barber or hair stylist is one thing,but can't investors simply rely on earnings reports andanalyst recommendations to find solid investments?

Unfortunately, earnings reports don't tell the wholestory, and Wall Street analyst recommendations areoften driven by motives that are less than pure. Over theshort term, a company's earnings per share can be madeto say just about whatever their management wantsthem to, and investors who focus solely on whether afirm beat or met the numbers are simply not getting thefull story. Analyst recommendations have historicallybeen a very poor predictor of future stock returns, andwhile the conflicts between investment banking andresearch may have lessened, they haven't disappeared.

Are there any obvious red flags that should standout if a company is not as reliable an investment as itfirst appears?

There are dozens, but you can focus on three forstarters. First, companies that post rising earnings butstagnant or declining cash flow are usually accidents waiting to happen. Second, companies that frequently takeone-time charges are usually bad bets, because they're tryingto sweep the results of bad business decisions intocharges that they hope investors will ignore. Finally, firmsthat grow by acquiring other firms bear close scrutiny,because their finances have likely been restated so manytimes that it's tough to tell which end is up.

Analyzing a company is one thing, but analyzingthe value of that company's stock is another story. Howdo you explain this process to your readers?

Valuation is in many ways the toughest part of theinvestment process. One place to start is to simply get a feelfor historical context. Look at a company's currentprice/earnings (P/E) ratio relative to where the P/E ratio hasbeen in the past. If it's a lot higher or a lot lower, ask yourselfwhether the company is fundamentally better or worsethan it used to be, or whether the market's mood has simplychanged. Also, become familiar with the fundamentalfactors that drive P/E ratios. All else equal, higher growthfirms should have higher P/Es, and higher risk firms andfirms with higher capital needs should have lower P/Es.

What are some of the factors physician-investorsshould consider when analyzing a company?

Break the analysis process down into four parts:financial performance, competitive position, corporategovernance, and valuation. You want to find a companywith the ability to generate increasing amounts of cash,the competitive strength to hold off rivals, a managementteam that acts in shareholders' best interests, and ashare price that offers a reasonable margin of safety relativeto its intrinsic value.

One feature that sets your book apart from all otherinvestment books is the "Guided Tour of the Market,"which analyzes 13 different sectors. Could you explainthe fundamental investment differences between thehealth care and retail industries?

That's an interesting comparison, because in manyways they are polar opposites. Retail companies are relativelyeasy to understand, but hard to predict. You buildnew stores, and you try to attract customers to thosestores. After all, a consumer can switch stores wheneverthey like, so it's tough for retail firms to develop long-termcompetitive advantages. Health care firms are much morecomplicated because of the scientific and regulatory issuesthey face, but they often have an easier time building economicmoats around themselves. As a result, the best onestend to remain the best for many years, which can makethem very rewarding long-term investments when they'retrading for attractive prices.

Pat Dorsey is the director of stock analysis forMorningstar, Inc. For more information, or to arrangean interview with Pat Dorsey, contact Jared Sharpe(212-593-6467; sharpej@plannedtvarts.com) or ScottPiro (212-593-6439; piros@plannedtvarts.com).