Cracking Open Our Portfolio Playbooks

In the Tortoise and Hare portfolios I manage in our StockInvestor newsletter, I focus on buying companies with wide economic moats that are trading at prices cheap enough to provide a margin of safety. Beyond this, there are a couple of other things I keep in our "playbook" to make sure I maintain a rational trading strategy. Some of these strategies are completely opposite of what many other investors and traders practice. This is fine by me. If everyone were using our strategy, there would be fewer chances to take advantage of market inefficiencies, fewer chances to buy things mispriced on the cheap. So let's crack open the playbook�

Not Our Style:
Saying, "Don't throw good money after bad."

In the Playbook:
Look to lower the cost basis when a stock has sold off and our thesis is unchanged.

It is not easy to buy more of a stock after it has gone down. After all, instinct is working against us. Watching a stock we own drop is a painful experience, and we are genetically wired to learn to avoid repeating painful actions.

In my opinion, ignoring this reflex is a key part of a winning investment strategy. If you strictly followed your instincts, you'd likely only buy more of the stocks that have recently gone up and avoid or sell things that have gone down. Remember, if you want to make money, you cannot get around the simple mathematical rule of, "Buy low, sell high." Buying low often means ignoring near-term pain and going against the grain, while selling high means not getting caught up in the market's euphoria.

We've used a "double down" strategy many times to great effect in our model portfolios. For instance, we first bought  CarMax (KMX) for the Hare for $33.71 per share (including commissions and trading costs) in January 2004. Over the next six months, the stock proceeded to lose nearly half of its value, eventually trading below $20 by the middle of 2004. This was clearly a painful experience.

Though there was the temptation to cut bait and stop the pain, our thesis on the company was essentially unchanged. CarMax remained well positioned to continue to gobble up market share in the used-car market.

By ignoring what the stock had recently done and buying it two more times--once at $27.12 and later at $21.51--we were able to lower the total cost basis on the position to $29.42 per share. Our timing could clearly have been better on the first purchase, but instead of sitting on a small paper loss on the position today (or worse, realizing a sizable real loss below $20), CarMax is now at a profit for us. Lemonade out of lemons, you might say.

Bill Miller of  Legg Mason Value Trust (LMVTX)--an investor worth listening to given his solid methods, which have led to a 15-year streak of beating the S&P 500--clearly has "doubling down" prominently in his playbook, too. I love how Miller has often summed up his strategy by saying, "Lowest cost basis wins."

Of course, there can be at times a fine line between smartly buying more to lower a cost basis and stubbornly ignoring when the fundamentals have changed for a company. Sometimes bad news really is bad news, so you should never buy only because something has fallen. Doubling down makes sense only if the market's lower perception of a business's value outweighs any real lowering of value. If your investment thesis has changed--if a company's moat has eroded, or profits and/or growth were not what you originally expected--it often makes sense to think twice before buying more. But if your thesis is unchanged, doubling down can be a very powerful tool.

Not Our Style:
Being attracted to things that are hot, hoping to buy high and sell higher.

In the Playbook:
Search for bargains among stocks hitting new lows.

I am a value investor to the bone. This does not mean I buy only "value" stocks as they are typically defined (low growth). Rather, it means I buy only at discounts to intrinsic value and try to sell at premiums to intrinsic value.

Frankly, you are more likely to find a stock trading at a discount among stocks that have recently performed poorly than those making new highs. (You can find bargains among the latter group, but not very often.) I love it when stocks on my watch list trade down and get grumpy when they trade up and away from me. Yet I am continually amazed at how many investors I meet outside Morningstar circles who have the exact opposite reactions to stocks that they are considering.

We also do not partake in the "greater fool" theory of investing, buying something we know to be overvalued on the hunch that someone else might pay an even greater overvaluation down the road. This is clearly what many investors in Internet stocks were doing in the late 1990s, and we can all see what happened there.

Not Our Style:
Aiming to hold positions only days or weeks, frequently trading in and out.

In the Playbook:
Patiently act like business owners, often holding stocks for years.

Embarking on a low-turnover strategy in our model portfolios not only keeps our transactional costs and tax bills relatively low, but also helps us to think like business owners. This sharpens our focus on what is important--competitive positioning, future cash flow, management and stewardship, etc.--and less on short-term market gyrations that are unpredictable.

I'm not just making anecdotal observations here. There have been several studies in recent years (Brad Barber and Terrance Odean's perhaps being the most famous) that have shown a high correlation between portfolio turnover and underperformance. In other words, the more you trade, the worse your performance tends to be, and vice versa.

Not Our Style:
Spending a lot of time looking at stock quotes and charts.

In the Playbook:
Pore over financial reports and get to know businesses.

In a perfect world, I would spend about 95% of my time researching stocks by crunching numbers, reading annual reports, scanning industry trade magazines and so on, and only about 5% of my time (or less) checking stock quotes or looking at charts. My reality is a bit more weighted on the "checking quotes" side of the equation than I would like. But I suspect I am not alone in this and get the impression that many investors have these proportions totally inverted from where they should be.

I've used this analogy in the past, but I think it is worth repeating. Just as you won't become a better baseball player by staring at statistics sheets, your investing skills will not improve by looking only at stock prices or charts. Athletes improve by practicing and hitting the gym; investors improve by getting to know more about their companies and the world around them. Go ahead and keep score, but don't let it be the only thing you do.

A longer version of this article originally appeared in the March issue of StockInvestor.