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By Jeremy Glaser and Paul A. Larson | 11-26-2012 02:00 PM

Larson's Strategies for Excess Returns

StockInvestor editor Paul Larson discusses the importance of investing in companies that can compound their intrinsic values, buying on the cheap, avoiding stop-loss orders, and more.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Almost as important as having a sound investment strategy is having the tactical tools to execute it well. I'm here with Paul Larson. He is Morningstar's chief equities strategist and also the editor of the Morningstar StockInvestor newsletter. We'll look at some of his top tips. Paul, thanks for joining me.

Paul Larson: Thanks for having me.

Glaser: Let's start off by looking at your big-picture strategy that you use in the StockInvestor portfolios. How do you try to generate those excess returns over time?

Larson: My strategy is a very basic two-step strategy.  And the first step is I focus on companies that have wide economic moats. These are the highest-quality businesses that are in the market, and these are companies that should compound in intrinsic value at above-average rates for long periods of time. So, these are simply high-quality businesses, and that's where I like to go fishing.

The second step of my strategy is to buy these companies only when their stocks trades at a margin of safety, and I define that as having the stock trade below its intrinsic value.

So, again there are two steps of the strategy: One, focus on the good businesses that are going to compound in intrinsic value; and two, buy opportunistically when they are trading on the cheap. And I really try and do both things.

Glaser: This is a pretty straightforward idea, but there are many things that can be a little bit more difficult to actually execute. What are some of the tactical tools that you use to really make the portfolio work? What are pitfalls to avoid?

Larson: One of the tactical strategies that I have is I avoid companies that are exposed to a lawless geographies, and this is something I learned the hard way personally a decade ago investing in a Russian company called Yukos that was basically bankrupted by the government.

But my pain in investing in Yukos I continually use today as a reminder that when you invest in lawless geographies the government is the one really holding the cards. So, no matter how great the company is positioning, how cheap the stock, or how fantastic the--if they're a mining company, if they have this fantastic mine--if they're in a lawless geography, I just try to avoid those situations.

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