Seven secrets of the investing masters

Want to do it like the professionals and profit from the stock market? Here are the secrets of the world's legendary investors

1. Benjamin Graham – Markets always over-react

Ben Graham was the father of investment analysis. While working in Wall Street in the 1930s and 1940s he invented many of the rules of thumb which are still widely applied today, and backtested them on historical stock market data.

He was the real pioneer of value (as opposed to growth) investing, producing accurate ways of measuring when stocks are cheap and therefore worth buying. His techniques pre-dated the days of computer stock screeners, but being purely quantitative they work beautifully with them.

However, one of his most appealing ideas was imaginative rather than scientifically rigorous. It concerned a fictitious stock market partnership that every individual investor is in, with a moody but persuasive lunatic called Mr Market.

This individual would arise each day in either a crazily optimistic mood, during which he would offer to buy out all your shares, or a black depression, in which he wanted to dump his shareholdings on you. Graham’s contention was that rather than being tainted by these moods and being miserable or happy with him, you should eventually yield to his suggestions.

So that means selling your shares when the market is full of optimism, and buying when the market is miserable. Graham showed that this contrarian position is the best way of exploiting market over-reaction.

2. Warren Buffett – Don’t buy what you don’t understand

There is no investor more frequently quoted than Warren Buffett, and it would be pretty easy to fill dozens of articles with his pithy sayings. However, it is what he has done rather than said that is the most amazing.

Buffett, a down-to-earth septuagenarian from provincial Omaha, Nebraska turned an original stock market investment of $100 in 1954 into $20 billion by 2002. He has followed many of the precepts of Benjamin Graham, but developed plenty of his own. Perhaps the most astounding of these is his ability to stand aside from a booming market, forgoing considerable profits, just because he didn’t understand what was driving prices.

In 1969 he did just that, winding up his partnership after 13 years of 30% compound growth. According to John Train’s book, The Midas Touch, Buffett told his partners: "I am out of step with present conditions…I will not abandon a previous approach whose logic I understand… in order to embrace an approach which I don’t understand..."

Three years later, in 1972, the market ran into the steepest collapse since the depression. Buffett was out, and in cash. The same thing happened during the late 1990s high technology boom. Buffett freely admitted he didn’t understand technology shares (an admission that should also have been made by the majority of investors who bought them.)

Though Buffett’s firm Berkshire Hathaway underperformed for a few years in those times, it emerged unscathed as the technology bubble deflated.

3. Peter Lynch – running winners

Peter Lynch ran Fidelity’s US-based Magellan Fund from 1977 to 1990, during which time its value soared 2,700%. During those bull market times he learned again and again that running winners was the key to outperforming the market.

He noticed that you would only need a few stocks that increased ten fold to give you massive out-performance. At the other end of the scale you need to get rid of the losers pretty quickly. The alternative apporach, practised by many investors, was to take profits at about 30 per cent but hang on to the losers, which he likened to watering the weeds and cutting the flowers.

The Magellan Fund had thousands of stocks, and Lynch was quick to admit that hardly any of them ever rose ten fold, but those winners he did have he wasn’t about to let go of quickly.

4. Anthony Gray – You don’t need to be immersed in the market

Tony Gray actually outperformed Peter Lynch for 12 years, when Gray was running a fund for SunTrust Bank in Orlando, Florida. In those years from 1981-1993, the fund increased on average 21.5% a year.

In three decades of investing, Gray said that he had only been to visit the New York Stock Exchange once. In his autobiography, appropriately enough called A thousand miles from Wall Street, Gray said that he felt no disadvantage being such a distance from the centre of trading. He also takes holidays, doesn’t call in to the office when he’s away, and doesn’t take stacks of work home in the evening.

The point is, if you have confidence in the stocks you are picking, and know their businesses well enough, you don’t need to be constantly fretting about details.

Perhaps Gray’s secret in this regard was that he picked companies which make products anyone can understand, from razors to toilet cleaner, from soups to soaps. Applying a value analysis and trading frequently, he was able to exploit small mis-pricings in the market.

5. George Soros – Trust your animal instinct

When George Soros retired in 2001, he took with him one of the most impressive investment records ever, and one of the most controversial.

The record speaks for itself. If you had put $1000 into Soros’s Quantum fund in 1969, it would have been worth $4m by 2000, a cumulative annual return of 32 per cent. However, Soros became notorious through his pioneering of hedge funds and the use of going ‘short’, which is to sell something you don’t own in the hope of buying it back more cheaply.

Soros proved that one wealthy individual can be as powerful as a major economy. In September 1992, Britain was teetering on the edge of being forced out of the Europe’s Exchange Rate Mechanism. The ERM kept fixed currency bands within which the pound was supposed to trade. Even with double-digit interest rates to attract international deposits, the currency was struggling, having entered the mechanism at too high a rate.

Soros saw the position was unsustainable and sold $10bn worth of sterling ‘short’, making a $1bn profit overnight as Chancellor Norman Lamont acknowledged defeat and allow the currency to crashed through the lower band.

Soros believes markets are chaotic, and the twists and turns of prices result from market moods. He always tried to spot those turning points, as he did the day he made a killing from the pound, but relied more on animal instinct than on analysis.

Strangely enough, according to biographer Michael Kaufman, Soros suffered from backache, and reckoned that the onset of a severe twinge was a sure sign that something was wrong with his market (rather than seating) position.

6. Jim Slater – The PEG ratio

Jim Slater first came to the UK public eye as chairman of the controversial secondary bank Slater Walker Securities. In the eight years to 1973 he turned £2,000 of savings into a financial conglomerate worth £200 million, but which then collapsed in a sea of debts a year later.

Nevertheless, Jim Slater is an able stockpicker, who pioneered the use of the price earnings to growth ratio, known as PEG. This formula compares the prospective price earnings ratio, i.e. the price of a company’s share divided by the expected earnings per share, with the company’s expected rate of earnings growth.

The PEG rule is that a company’s shares may be good value if its rate of earnings growth exceeds its forecast P/E ratio. So if a company with a forward P/E of 10 is consistently increasing its earnings by 15 per cent, then it is worth closer examination.

This handy tool, first outlined in Slater’s book the Zulu principle, works best for consistent increases in earnings. The main drawback is that for much of the market cycle, all the best growth shares are actually poor value under a PEG analysis, yet still keep edging up in price.

7. Anthony Bolton – Look for business franchise strength

Britain’s answer to Peter Lynch, Anthony Bolton has consistently outperformed the market during the last five tumultous years, during which the Fidelity Special Situations fund he runs has doubled in value. With a team of 50 analysts working for him, he isn’t short of number-crunching clout. But what is he looking for?

In a question and answer session with independent financial advisers in December, Bolton said that he looked for business franchises with enduring strength and strong cash generation, which in the UK tended to steer him towards service businesses and away from manufacturing.

He tends to take an 18-month view on a stock, but can be patient for longer than that on some occasions.

As for the future, Bolton reckons that the new bull market will keep going for a while yet. After nine months of the rebound he is impressed by the technical strength of price rises, and believes that, given the duration of bear market we have recently come through, he would be surprised to the bull market end so soon.