:: creative : investor : 101 ::: Morningstar's Investing Strategy

I whole-heartedly agree with the investing strategies suggested by Morningstar and outlined below. This is definitely part of a value-investing approach, particularly as manifested by Warren Buffet's investing style.

This strategy fits in well with Morningstar's 20 Stock-Investing Tips.

1. Look for Wide-Moat Companies.

The fat-pitch approach is best described as buying above-average (wide-moat) companies at prices that provide a margin of safety to your fair value estimate.

Companies with wide economic moats reside in profitable industries and have long-term structural advantages versus competitors. These companies are fat pitches with predictable earnings, returns on capital higher than the cost of capital, and long-term staying power.

The beauty of a wide-moat company is that the odds are pretty high that the actual intrinsic value of the firm will increase over time, leading to higher shareholder value. In other words, time is on your side with these companies.

We recommend maintaining a watch list of wide-moat companies that you consistently monitor for any opportunities.

2. Always Have a Margin of Safety

Buy a stock only when it's selling at a decent margin of safety to your estimate of its fair value. Don't even think about the overall direction of the stock market, because that's impossible to predict with any consistency. By doing this, you'll need to exercise a lot of discipline and wrestle with the fear of missing out on a market rally. Patience is indeed a virtue when using this approach because oftentimes it may take many months, or longer, before a fat-pitch opportunity presents itself.

Think only about individual wide-moat companies; if you find one where the price is irrationally low relative to its long-term intrinsic value, consider buying it. If not, hold off for a fatter pitch.

Also, you must determine how much of a margin of safety you'll require before buying a stock. If the firm is not very risky, you could be content with a 15%-20% discount to its fair value. If the firm is riskier than average, you may demand a 30%-40% discount. Ultimately, it's your decision.

The beauty of fat-pitch investing is that it has two built-in factors that help offset the risk that your fair value estimate is wrong. First, by requiring a margin of safety, you've given yourself some "error cushion," just in case your estimate was too high. Second, by purchasing wide-moat companies, chances are high that the firm will increase in value over time. Thus, even if your estimates were way off, the firm--and its stock price--will likely appreciate in value, eventually catching up to your fair value estimate. In effect, by buying wide-moat companies, you have another margin of safety built into your investment.

3. Don't Be Afraid to Hold Cash

For instance, many professionals getting paid to invest other people's money feel they are actually required to stay fully invested even if there's a lack of fat-pitch opportunities. Thus, when the market drops, they often can't do anything but watch (or worse, sell out near the bottom).

So if the market isn't throwing you fat pitches, just hold on to your cash and wait until it does, because fat-pitch investments are much more likely to provide strong absolute returns over time.

4. Don't Be Afraid to Hold Relatively Few Stocks

Remember, it takes great patience to be a fat-pitch investor, but when opportunities present themselves (nice fat pitches right down the middle), you should buy boldly (swing away).

We caution you, however, that it's risky to hold a concentrated portfolio (few positions) unless you do three things:
1. Buy only wide-moat companies, which will increase in intrinsic value over time.
2. Buy them only at a significant discount to fair value (a margin of safety).
3. Have a time horizon of at least three years on each pick you make. It may take this long (or longer) for the market to recognize the value of a company.

5. Don't Trade Very Often

Think of it this way: Investing is nothing more than a game of probabilities. No matter how diligent you are, your fair value estimate for a stock will never be exactly right. It's really just an estimate of what a stock is worth under the most likely scenario for future earnings growth and profitability. Thus, there's always less than a 100% probability that you'll be right about a stock pick. Given that the odds are below 100%, there's little point in trading from one stock to another frequently; your odds of being "right" on the new pick are probably only a little higher than the odds of being wrong on the current pick.

Add to this the costs of trading--including taxes, bid-ask spreads, and commissions--and the odds of generating higher returns by trading frequently are worse than simply buying great stocks at good prices and holding them for three years or more.

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