Do you know how anyone with no financial background can outperform professional investors? It's easy: Follow a smaller number of companies and truly understand what they do.
Behind every stock, there is a company and a story. By doing your homework, you can learn the intricacies of a particular company and if it is a viable investment option. To be optimally diversified, you need to own stock in eight to 20 different companies. Over-diversifying may cause you to lose the advantage of concentration, as it's easy to lose focus if you're trying to track too many different companies. In short, it takes only a small number of big winners to make a lifetime of investing worthwhile. And if you can't find any companies that you think are attractive, then keep the cash. Investing for the sake of investing is foolish.
Also, beware of stocks in hot industries such as technology. These companies can fall just as fast as they went up, so you are better off finding good companies in slow industries that have been consistent winners. They should dominate their industries and return billions to shareholders in the form of dividends and share buybacks each year. StreetAuthority Co-Founder Paul Tracy calls these the World's Greatest Businesses, or WGBs for short.
I think this is exactly the kind of stock you should look for to form the core of your portfolio. Here are five traits I recommend looking for in a WGB...
1. Brand loyalty: Many people are more willing to pay a premium for any number of perceived values (luxury, trust, reliability). Some examples in the car industry would include Lexus, BMW, or Mercedes. Does your stock have built-in brand loyalty?
2. Patents, copyrights or trade secrets: These make direct competition very difficult and help create what Warren Buffett and Benjamin Graham call "wide moats". Personally, I wouldn't buy a single stock that didn't have some kind of moat. Some examples would be a drug company's patent on a profitable drug or a copyrighted computer technology.
3. Service fees: The collection of fees gives businesses a dependable, recurring revenue stream, and usually accompanies exclusive access to a particular market. Examples would include utility companies, master limited partnerships (MLPs) and royalty trusts. These kinds of stocks often make for great income investments, as the high amount of reliable cash flow often makes its way back into the pockets of shareholders.
4. Switching costs or price advantage: Have you ever tried to switch your cellphone plan? What about your cable TV provider? It's an absolute headache. The time you'd have to spend on hold waiting to speak to someone in customer service is often enough to discourage customers from switching, not to mention the ridiculous fees they charge for voiding your contract. And whether AT&T (NYSE: T), Time Warner (NYSE: TMX), or Verizon (NYSE: VZ) want to admit it, it's usually by design. Other examples might include utilities, banks, payroll services or financial services companies.
5. Staying power of the competitive advantage: Another aspect to consider is the long-term staying power of the competitive advantage. Take technology companies for example. They may have a competitive advantage today, but it can go out of favor very quickly if the company does not keep pace with the new technologies. That's why it is easier to spot sustainable competitive advantages in companies that have a long history. Wal-Mart (NYSE: WMT) is a great example. It would be one thing if the retailer just suddenly came out of nowhere and was able to beat the competition with lower prices, but Wal-Mart has been able to do this year-in and year-out.
Risks to Consider: When it comes to investing, there's never a no fool-proof plan. Stocks go up and down every day, no matter how good of a company they are. No matter how many of these five factors a company has, it still can go down for a period of time.
Action to Take --> If you can't answer "yes" for at least one of these five items, then chances are your company is not one of the World's Greatest Businesses.
When you choose dominant, shareholder-friendly companies, you're investing in proven companies that stack the odds of success in your favor. By using this five-part check up with each stock in your portfolio, you may be able to either spot danger ahead or validate why you bought the stock in the first place. And you also stand a good chance of beating the pros.