Beat the market with just two shares

One of the most common pitfalls of individual investing is owning too many shares. Is it any wonder? Vying for …

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One of the most common pitfalls of individual investing is owning too many shares.

Is it any wonder? Vying for our investment dollars, we find so many alluring companies exploring for iron ore, uranium or coal. Add in the odd biotechnology concern and some appealing market stalwarts in beverages, software, pharmaceuticals and banks, and before long, you own representatives of most every major industry, and by virtue, the market itself.

Even if this type of strategy produces market-beating gains, it's a strategy encumbered by numerous transaction costs, substantial record keeping, and an obligation to track the progress of all these companies on a regular basis.

Index Plus A Few (IPF)

There is an alternative way to beat the market, a way distinguished by simplicity and logic, which we call the "Index Plus a Few" strategy, hereafter simply IPF.

As the name implies, IPF is a hybrid strategy mixing the best aspects of index tracking funds and individual shares. On the 13 Steps To Financial Freedom, it'd probably land around Step 11, somewhere between straight-out index tracker investing and a diversified portfolio.

IPF is a simple two-pronged portfolio strategy. The first prong stems from our fundamental goal as investors of at least matching the average return of the S&P/ASX 200 or 300.

The easiest way of achieving this goal is to allocate a significant portion of the portfolio — say, 60-80% — to a fund like the Vanguard Index Australian Shares Fund (ASX: VAS). This ETF trades just like an individual share and exactly matches the return of the S&P/ASX 300.

The second prong, which is aimed at extending our returns beyond the market's average, is to allocate 20-40% of the portfolio to a few — as in, one or two — individual companies. The key here is identifying truly great companies, just one or two that you know inside and out, and that have the potential to be market-beating long-term winners.

How do you find these companies which are, admittedly, few and far between? Intellectual curiosity and plenty of reading of all things business-related go a long way in separating the wheat from the chaff.

4 Key Questions

This strategy relies upon an upfront investment of time in studying industries, business models, and management. In an interview with The Motley Fool, Yahoo!'s ex-CEO Tim Koogle identified four key questions to ask yourself as you consider a company's investment merit:

1) Is the company, or can it be, a leader in its market?
2) Is it addressing a market that's truly big and growing fast?
3) Is the fundamental business model a good one so that it can actually become cash flow positive and achieve profitability?
4) Is it well managed?

Together, those rather simple questions get to the heart of whether a company has the ability to build shareholder wealth over a period of not just years, but maybe even decades.

To answer those questions, you need to really understand a company through and through.

Identifying The Winners

When you identify a potential winner, you'll want to concentrate your investment study and dig deep to learn as much as possible about the underlying business.

You'll want to read the annual report, read the earnings releases, assess the valuation, use the company's product/service, and read articles and books related to your company. Whew! That's a lot, yes, but if business fascinates you, and you love to learn, then this stuff actually should be a lot of fun.

Doing these things will provide you with a thorough understanding of a company's industry attractiveness, its position in the industry, and its business quality.

These specific insights on just one or two companies are what will give your IPF portfolio its market-beating ability. Let us emphasise that you should know these one or two companies so well that you don't have any fear in allocating 20-40% of your portfolio to these holdings.

Lower Your Risk

An IPF portfolio is actually a low-risk strategy, too. You can't beat the diversification of an index, and your concentrated bets on a few companies are bolstered by deep knowledge.

A favourite definition of risk is that risk is not knowing what you're doing.

As long as you have a genuinely rock-solid understanding of why your one or two companies are poised for long-term success, then your portfolio isn't any riskier than the market as a whole.

This strategy is totally contrary to conventional industry wisdom, but we think allocating a major portion of your portfolio to a few companies that you know exceedingly well is the easiest way to beat the market.

So, if your portfolio more closely resembles a share collection than a deliberately designed portfolio, and if you're attracted to a simple, efficient, and rigorously logical way to beat the market, then you might want to consider restructuring your portfolio with the IPF in mind.

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