How did Fred Hager beat the average Mutual Funds by more than 300% a year for twelve years?

I believe this advice will be worth thousands of dollars to you if you consider my points seriously and act on them.

If you think about the key to my investment record, you will realize it is nothing but common sense based on familiarity with the computer technology sector.

The strategy is very important, but what is more important is the kinds of stocks you choose to buy.

Surely you are aware of the fact that the average mutual fund has lagged the market. A recent study revealed that even the index funds beat their average non-index brethren. Some of the best fund managers think it is an achievement if they beat the market averages by a couple of points.

Why do you think the mutual fund industry as a whole has such a poor record, and on average, the funds don’t beat the market?

And how is it that I can beat the average fund by more than 300% over twelve years?

It really is very simple. The Funds don’t have it easy. The mutual fund industry has to operate under difficult conditions with both hands tied behind its back.

These restrictions and limitations usually imposed by their charters vary widely, from the obvious restrictions of sector funds to specific sectors, to specific geography, minimum diversification, maximum percentage holding per security, minimum cash requirement, and so on. In addition, the race for short-term performance has affected many funds negatively. Moreover, in order to keep within their charter, which permits only a certain percentage position in any security, most funds are forced to cut down the positions of their big winners in order to stay within their limit for individual holdings. Of course, the ugly ducklings do not present a problem and can therefore be held. This is especially true for index funds.

Since there is no meaningful performance difference over a period of time between index funds and other mutual funds, lets look at index funds.

If you buy an index fund, you buy a whole universe of stocks. You buy the good the bad and the ugly.

Why, for heaven's sake, should you buy the bad and the ugly? In addition, you are buying the same amount of a bad stock as you are buying of a good stock. You are doing that with your hard-earned savings, and that to me seems to make no sense at all. Of course, you can’t blame the index funds - they are doing exactly what they promised. So why are there so many index funds? That also has a simple explanation: they can prove they do as well as the average mutual fund. The net effect is totally counter-productive.

While all the above points apply more or less to the non-index funds, the non-index funds with their greater turnover, larger commissions, higher expense ratio, etc. have an additional set of negatives affecting their performance, not the least of which is a higher tax liability created by the higher turnover.

On the other hand, my approach is relatively simple. Here are the keys:

Key One: Sector

• I only concentrate on the computer technology sector, which is the fastest growing sector in the American economy. This gives me an unfair advantage. It also is the sector with which I am the most familiar. (see my background)

Key Two: Selection

• I concentrate on portfolio performance by picking only the securities I believe to be among the best of the best, la crème de la crème. My twenty-year background as an executive of a computer company helps me greatly in assessing the long-term merits of the companies I select. I only pick stocks with which I am totally familiar; stocks that are market leaders or very special situations. I anticipate the earnings of my stocks to grow at a rate of at least 25% per year for the next five years. Special situations are only considered if growth can be reasonably expected at a much higher rate, in order to increase my overall performance rate. My target rate average for my two portfolios is 35% per year, which to date has been exceeded. It is, however, important to keep in mind that the past record in no way assures success in the future, and that my anticipations may prove flawed.

Key Three: Minimum turnover

• I will trade very seldom in my model portfolios in order to minimize tax consequences for investors. In spite of my track record, I have made many mistakes, most of them were the result of too much trading. The more you trade, the more chances you have to make mistakes. For all of 1998, I did not make a single trade. In spite of that, I was up 100%, and no taxes were applicable.

Key Four: Concentration

• I will not have more than three to five stocks in my portfolios. I have averaged over 35% per year since 1986. If I can do the same over the next five years, a $10,000 investment, compounding at 35% for five years, will grow to an amazing $44,840. What is wrong with that?

Key Five: Never try to time the market

• Nobody can time the market. There are no timing gurus that have a long-term record of being right. The more arrogant they get, the harder they fall when the law of averages catches up with them. Just look at the awful recent records of "so-called" former greats like Granville and Garzarelli.

Key Six: Don’t let anybody chase you out of a good stock when it hiccups

• The secret is ignoring the pundits when they place the stock on a sell list. Or when they downgrade it to hold or neutral and tell you there are better opportunities elsewhere. Can you imagine the damage done by these guys to investors chasing them out of good positions?

  An example: Let us assume an investor has a position in Intel. He paid $20 a share for it. Four years later, Intel hits $100, then slides back to $75 because of some negative news (which is of little long-term consequence). Now major brokerage houses reduce their estimates and tell their customers there are better opportunities for the near term. It works. Intel’s daily volume reaches 75 million shares. A lot of scared people are selling, and a lot of smart people are buying. Of course, this creates millions of dollars in broker commissions. A few days of these negative stories force the stock down to $69. A lot of investors are worried about losing more money and sell out. After all, as they say, you can’t make a mistake by taking a profit. Twelve months later, Intel is back at $100, reaches a new high and breaks out to $110. At this time, all major brokerage houses come out with a buy on Intel. It now trades at $115. The investors who sold Intel at $69 always liked Intel, after all, it made lot of money for them over the four years they held it. So, they buy it again at $115.

  Let’s analyze this recurring phenomena. The first thing they did is created unnecessary income of $49 per share when they sold it. This created a tax liability of about $13.50 (state and federal income tax depending of where they live.) In addition, there are the commissions and the spread.

  The worst part is now they have to make 100% profit to be back where they were before they lost the 50% by being out of Intel while it went from $69 to $115.

Key Seven: Don’t panic during a market break

• The same financial scenario applies as mentioned in the above example. When the market dives 20% or more, it officially becomes a bear-market. Investors are advised to lighten up their portfolios by brokerage houses. 95% of the time, the market turns around at this level, and investors, after taking their profits, and after missing the first part of the new bull move, are now considering entering the market with their reduced resources

Fred Hager offers an investment letter at Fredhager.com that I heard of first years ago and which I found immediately interesting in the same way I do today.