How we beat the market

Nearly a decade ago, at the height of the dotcom bubble, I joined a band of my fellow Vancouver Island schoolteachers in a quest for riches. We formed an investment club, pooled our money and started to buy Internet stocks. We thought we were canny investors speeding down the highway to wealth.

In fact, we were drunks careening along the edge of a cliff called Nasdaq. When the market crashed, we fell and fell. Then we fell some more. Rock bottom didn’t come until our account dropped 60% below what we had initially invested.

Our story could have ended there. We might have resolved never again to touch the stock market. We might have gone back to sticking our money in GICs and bank accounts.

But we didn’t. Once our groans subsided, we decided to get a lot smarter about how we invested. We eventually crawled our way back to profitability. By 2004, we had caught up with the S&P 500 index of blue-chip U.S. stocks. Since then, we’ve pulled farther and farther ahead.

Smart investing isn’t easy. It is, however, more straightforward than you think. Let me explain how we turned around our portfolio — and how you can too.

Our investing club was started by Grant, an intense math teacher. After watching the market surge in the craziness of the late ’90s, he decided to cash in his underperforming mutual funds. He told his financial adviser, “I think I can beat you on my own.”

To join him in his assault on the stock market, Grant recruited 14 of his fellow teachers. We were a diverse lot: four women and 10 men who taught subjects ranging from English to physics. Two of us were just starting out; two others were on the verge of retirement. What we shared was a burning desire to make bucket loads of money.

In 1999, as we started our careers as investors, our ambitions seemed reasonable. Every stock we bought shot upward and our fellow teachers dubbed us the Millionaires Club. We trumpeted our success in the staff room and we subjected our less fortunate peers to play-by-play details of our big wins with stars such as Nortel Networks, Global Crossing and JDS Uniphase.

The staff room had the last laugh. About a year after we launched the club, the dotcom bubble began to deflate. It burst in late 2000. Rather than winding up rich, we wound up bitter, embarrassed — and poorer than we had been two years earlier.

Grant, our founder, had had the wind knocked out of him. While he gamely continued to show up for meetings, he announced that his stock picking days were over. Three other members quit in disgust. The disillusioned dozen of us who remained plugged away, each of us adding between $50 and $200 a month to the club’s account. We had a long way to go. The S&P 500 had taken a hammering during 2001, but it was still 30% better off than we were.

Realizing that there was no easy way to grow rich, we did a lot of reading, particularly about Warren Buffett, the world’s greatest investor. With Buffett as our model, we embarked on a systematic pattern of buying profitable businesses that were out of favor. We wanted great, financially sound companies that we would feel comfortable owning forever, even if their share prices were temporarily down.

Our new strategy isn’t complicated, but it has performed splendidly. Since 2001, we’ve averaged 14% annual returns. Even during the past year, when stock markets tumbled, we eked out a small gain. Our joint account is now above $310,000. Looking back, I attribute our success to five principles:

We buy businesses that make money This rule sounds obvious, doesn’t it? Trouble is, not everyone pays attention to it.

During the early years of our investment club, a stockbroker named Peter used to call my house to give me his tip of the week. Peter wanted our investing club to open an account with his firm because he knew we changed stocks more often than we changed our underwear. He figured we could generate a fortune in commissions for him. “Here’s something you guys are going to like,” he’d say. “This stock is going to be a 10-bagger if you can get in early.”

There was only one problem. Peter never knew anything about the businesses he promoted. If I asked him what the debt levels were, or what the return on total capital was, he couldn’t tell me. I would ask: “Peter, does the business make any money?” He usually didn’t know. If we had listened to Peter, we would have invested in nothing but junior mining companies, high-tech startups, and the like. Luckily, the dotcom crash immunized us against people like Peter. We never bought anything he promoted.

We’ve learned over the years that making money is tough even if you stick to investing in businesses that already make a profit. Making money with companies that have yet to turn a profit is next to impossible. Stockbrokers will sing hymns of praise to the amazing potential they see in small, young companies, but the reality is that junior mining companies don’t find gold and that struggling tech companies don’t become the next Microsoft. (Yes, there are exceptions, but they’re so rare that you should forget about them.)

We started to do well only when we began buying businesses with long histories of profitability. Most of our holdings produce simple products that people use again and again — Anheuser-Busch, the beer maker, has been one of our largest holdings for two years, and is a perfect example of our approach. My fellow teachers and I know that we’re not smart enough to forecast the next big thing. We can’t evaluate a tiny pharmaceutical company with a revolutionary cancer cure or a Chinese electronics manufacturer with a new way of producing microchips. So we look for strong businesses in profitable industries that we can understand.

Our strategy means that we give the cold shoulder to many industries. Airlines, for instance, are out. Over the course of its entire history, the aviation industry has been a money-loser. Just look at all the airlines, such as Wardair, or Pan Am, or Canada 3000, or Zoom, that are no longer around.

On the other hand, we love beverage makers and Coca-Cola is one of our biggest holdings. We know the world’s biggest pop maker is not going bankrupt anytime soon. We love its regular, dependable earnings — and we know that those earnings don’t depend upon it making a breakthrough in research and development. To be a good investment, all Coca-Cola has to do is to keep on selling more and more of the fizzy stuff. We have tremendous faith that it will.

A few years ago, we bought Coke at $39 a share. It’s now above $51 — and it’s paid us hefty dividends at every step along the way.

We know how to do nothing I shudder when I remember how often our investing club used to trade. We would wait for the latest report from George Gilder, one of the most popular gurus of the dotcom boom, then jump on whatever stock he recommended. We made more than 15 trades in our first year.

Now we might make one trade a year. Two trades in 12 months would constitute a frantic rush of activity for us. Rather than trying to imitate Gilder — whose picks crashed and burned with the dotcom debacle — we model ourselves on Buffett. He’s made billions of dollars as an investor, but he doesn’t do much trading. When he sees a business he likes — whether it’s Coca-Cola, The Washington Post Co. or American Express — he buys and never sells.

We’re suspicious of “miracles” Just in case you’ve mistaken us for a bunch of investing geniuses, let me tell you about one of our club’s worst moments. The story begins in 1999, when a friend tried to convince me to invest in a payday loans company on Vancouver Island that promised to pay its investors 54% per year in interest. I know what you’re thinking: that’s nuts. That’s what I thought, too. My friend, though, liked the company’s story. It claimed to have perfected a no-risk way of making short-term loans to high-risk people. It took title to the borrower’s car when it made a loan. If the customer defaulted, the loan company would take possession of the customer’s car, resell it and recoup the money it was owed.

It still sounded fishy to me, but my friend put in $85,000. He was one of the company’s earliest investors and he proceeded to collect $45,900 a year in interest for seven straight years.

It is hard to sit and watch while a friend makes truckloads of easy money. Finally, the temptation was too much. In 2005, our club invested $24,000 in the business.

Within a year, we had lost it all. It turned out that the loans company wasn’t making much money on loans. It was simply taking new investors’ money and using it to pay old investors. When the truth was finally revealed, the business collapsed.

Consider it a lesson well learned: if something sounds too good to be true, it probably is.

We’re greedy when others are fearful As much as we love great companies, we don’t want to overpay for them. We want to buy great companies when they’re on sale.

How can a bunch of schoolteachers, thousands of miles away from Bay Street, hope to spot such opportunities? It’s easier than you think. We’ve found over the years that the market is manic depressive. Some days it sees only the good side of companies. Other days it sees only the problems. If you can discipline yourself to buy when others are at their most fearful, you can make a lot of money.

A case in point came when George Bush ordered U.S. troops into Iraq. We’re a peace-loving group, but we figured the start of war would mean a great buying opportunity. In March 2003, while other investors hung back, waiting to see how the war would affect the global economy, we bought the best company we knew: Warren Buffett’s Berkshire Hathaway. We paid $2,150 a share. Today, each share is worth $4,400.

It’s tough to go wrong if you buy quality companies when they’re out of favor. A couple of years ago, we started to buy stock in Wal-Mart. We liked the giant U.S. retailer because it was highly profitable, had a long track record of growing its earnings at about 10% a year, and paid a steady dividend. Yet despite being the dominant firm in its industry, its stock hadn’t budged for years. Most investors believed that Wal-Mart was too big and too boring to produce strong returns. It’s only been during the past year, as the global economy has slowed and shoppers have become more price conscious, that the king ofdiscounters has finally earned some respect. Wal-Mart’s stock has soared 40% over the past few months.

We bought Anheuser-Busch in 2006 when its stock slipped to $45 a share. The market was worried that beer consumption was slowing in the U.S. But we researched the company and found that Anheuser-Busch was the fourth-largest brewer in China. The Chinese drink more beer than people in any other country, so we figured there was opportunity for growth. The market has since come round to our view. Our shares are up 55%, including dividends.

Of course, it takes patience to buy unpopular companies. Two drug makers — Pfizer and Schering-Plough — are part of our holdings, as is Simpson Manufacturing, a maker of construction connectors. All three stocks are out of favor—and we’re happy when they fall even further. Yes, you read that right. Back in 1999, we rejoiced when the market rose. Today, we celebrate when the market drops, because that gives us a chance to buy more good stocks for less.

You don’t have to buy individual stocks to take advantage of this contrarian strategy. If you’re a mutual fund investor, just ask yourself when you’re most inclined to invest. If you’re like most people, you put money into your funds after they’ve had a great year. You put little or no money into your funds after they’ve had a bad year.

Follow this pattern and you’re sabotaging yourself. You’re buying more units at a high price and fewer units at a lower price. So reverse things: force yourself to invest more when the market is down. At the very least, stick to a disciplined strategy of investing equal amounts each month no matter what the market is doing.

We keep our pride in check Our investing club is proud of its results. But we’re realists. We know we don’t know much about European or Asian stocks so we’re happy to invest in them through a low-cost index fund that tracks the international markets. When we buy stocks, we stick to big U.S. names, because the U.S. market is easy to research. Even then, we don’t get carried away. Every year, we compare our performance to that of the S&P 500 index of big U.S. companies. If we do worse than the index for an extended period, we will stop trying to beat the market, and become index investors.

So far we haven’t had much to worry about. After nine years, despite some bonehead decisions, our portfolio is up on the S&P 500 by roughly 50%. Our stocks have outperformed the index for six straight years.

We think we have a good chance of continuing our run, because of the lessons we’ve learned along the way. We’ve discovered that keeping our emotions in check is vital to good investing. We’ve found that forcing ourselves to stick to good companies is crucial. Most of all, we’ve learned to be realistic about what we can do well and what we can’t. None of those lessons is complicated, but each has helped to make our little band of teachers a nice sum of money. They can do the same for you.