Morningstar believes there are important lessons to be learned from the world's most successful investors. Here is the second instalment in our series on their investment philosophies and strategies.

 

Seventy-five years ago, Sir John Templeton made a legendary move at the start of World War II. In September 1939, he was sitting in his office at Rockefeller Plaza in Manhattan when the news broke out that Hitler had invaded Poland. It was obvious that this would lead to a full-fledged war.

He was no millionaire at that time since his Wall Street career was launched a year or two before. So, he borrowed money to buy 100 shares each in 104 companies selling at $1 per share or less, including 34 companies that were in bankruptcy.

A few years later, he made a nice tidy profit after paying off his debt. Only four (out of 100) turned out to be worthless.

When asked during an interview what made him do it, he answered: "During war, everything that was in surplus, and therefore unprofitable, becomes scarce and profitable."

This story aptly sums up Templeton's investing philosophy, which thrived on pessimism--when it was prevalent in the market. He, on the other hand, tended to brim with optimism at such times. In a tongue-and-cheek fashion, he used to state: "When people are desperately trying to sell, help them and buy. When people are enthusiastically trying to buy, help them and sell."

To his credit, he put his money where his mouth was. In 1978, he started accumulating a stake in Ford when it looked like it was headed for bankruptcy and its shares were at around $2 (split-adjusted). He kept buying the shares even as they slid to around $1 by 1981. In a couple of years, he was vindicated. By 1987, Ford had zoomed to $15.

When everyone else piled into technology stocks in 2000, he was a seller. In an interview in 2001 with Forbes, he said he was appalled at the market's frothiness. "This is the only time in my 88 years when I saw technology stocks go to 100 times earnings; or, when there were no earnings, 20 times sales. It was insane, and I took advantage of the temporary insanity."

Templeton is said to have almost single-handedly pioneered global investing. When growing up in Tennessee, he never encountered anyone who owned shares. That changed when he studied at Yale University. There he rubbed shoulders with boys from wealthy families but noticed that not one of them was investing outside the US.

Surely, he figured, they would get better results if they diversified across the globe and did not limit their investments to one country. He aggressively searched but could not locate an investment counsellor who specialised in helping people invest outside America. Instead of seeing this as a drawback, he saw a wide-open opportunity.

Even across borders, he followed the same principle--hunt for undervalued stocks in the midst of pessimism.

In 1980, a Maoist guerrilla organisation called the Shining Path took over Peru, imposing what it called "a dictatorship of the proletariat." Western economies branded the organisation a terrorist group and curtailed economic activity.

The Peruvian stock market collapsed. Peruvian stocks were dirt cheap but Templeton could not get his hands on them as foreigners were not permitted to buy stocks in Peru. But the bargains available were too tempting to ignore. So, he formed a Peruvian corporation and used it as a holding company to buy up the nation's leading companies.

When the reign of the Shining Path ended and political stability was restored in Peru, economic activity picked up, taking the Peruvian stock market along with it. John Templeton won hands down.

He is said to be the first Western investor to see the potential of Japan's post-war economic miracle. When Templeton began investing in Japan in the 1960s, it was considered an emerging market and a risky investment adventure.

At that time, he found stocks trading at a P/E ratio of only 4 times his estimate of earnings while stocks in the US were trading at around 19.5 times. At that time, the Japanese economy was growing faster than the US but most stocks cost 80 per cent less than the average of stocks in the US.

When Japan finally pulled all restrictions on foreign investors in its stock market in the 1960s, Templeton grabbed the opportunity. Japan's growth rate continued to soar and by 1985 the country had exploded onto the economic landscape.

As the rest of the world woke up to what was happening in Japan and the stock market soared, Templeton had already made a fortune for his investors. Not surprisingly, at the peak of Japan's stock market bubble in 1989, when valuations were very high, he was significantly underweight the country.

Whatever be the stock, industry, or country, when it came to value investing, Templeton believed the best bargains could only be found "at the point of maximum pessimism." The Wall Street Journal aptly titled his obituary "Maximum Optimist," since his optimism in the face of bleak pessimism was his greatest weapon as an investor.

In Investing the Templeton Way, a book co-authored by John Templeton's great-niece, the strategy of purchasing shares in the wake of a crisis is detailed.

1) The bargain hunter searches for stocks that have fallen in price and are priced too low relative to their intrinsic value.

2) The bargain hunter searches for situations in which a large misconception has driven stock prices down, such as the arrival of near-term difficulties for a business that are temporary in nature and should correct over time. In other words, bargain hunters look for stocks that have become mispriced as a result of temporary changes in the near-term perspectives of sellers.

3) The bargain hunter always investigates stocks when the outlook is worst according to the market, not best.

A crisis sends all these events into overdrive. Put another way, when the market sells off in a panic or crisis, all the market phenomena a bargain hunter desires condense into a brief and compact period: maybe a day, a few weeks, a few months, perhaps even longer.

To take advantage of such a crisis, the investor must be prepared. Make your decision to buy when you are thinking clearly and your judgment is not being affected by the events at hand. Having done that, maintain a discipline of purchasing stocks that you believe to be a bargain.

Templeton used to make his buy decisions well before a sell-off occurred. He always kept a "wish list" of securities or companies that he believed were well run but priced too high in the market. In fact, he often had standing orders with his brokers to purchase those stocks if for some reason the market sold off enough to drag their prices down to levels at which he considered them a bargain.

In the foreword to the book, he pens down words of wisdom that any value investor should ardently follow: "One principle that I have used through my career is to invest at the point of maximum pessimism. That is the time to be most optimistic."

"Buying when others are despondently selling and selling when others are avidly buying requires the greatest of fortitude and pays the greatest ultimate reward."

Here are six "buy" rules to follow to be a successful investor. These are taken from Templeton's timeless observations in Rules for Investment Success.

Buy for the long term

Do not trade or speculate. The stock market is not a casino, but if you move in and out of stocks every time they move a point or two, or if you continually sell short, or deal only in options, or trade in futures-- the market will be your casino.

And, like most gamblers, you may lose eventually--or frequently. By trading frequently, you also have to deal with capital gains tax and brokerage.

Sometimes you won't have sold when everyone else is buying, and you'll be caught in a market crash. There you are, facing a 15 per cent loss in a single day. Maybe more. Don't rush to sell the next day. The time to sell is before the crash, not after.

Instead, study your portfolio. If you didn't own these stocks now, would you buy them after the market crash? Chances are you would. So, the only reason to sell them now is to buy other, more attractive stocks. If you can't find more attractive stocks, hold on to what you have.

There will be corrections and crashes. But, over time, studies indicate stocks do go up, and up, and up.

But buy and hold is not synonymous with buy and forget. Don't get complacent. No investment is forever.

Buy low

It may be obvious, but that isn't the way the market works. When prices are high, a lot of investors are buying a lot of stocks. Prices are low when demand is low. Investors have pulled back, people are discouraged and pessimistic.

Yes, they tell you: "Buy low, sell high." But all too many of them bought high and sold low. Then you ask: "When will you buy the stock?" The usual answer: "Why, after analysts agree on a favourable outlook."

This is foolish, but it is human nature. It is extremely difficult to go against the crowd--to buy when everyone else is selling or has sold, to buy when things look darkest, to buy when so many experts are telling you that stocks in general, or in this particular industry, or even in this particular company, are risky right now.

But, if you buy the same securities everyone else is buying, you will have the same results as everyone else. By definition, you can't outperform the market if you buy the market. And chances are if you buy what everyone is buying you will do so only after it is already overpriced.

Buy quality

Quality comes in different forms. It could be a company strongly entrenched as the sales leader in a growing market; a technological leader in a field that depends on technical innovation; a strong management team with a proven track record; a well-capitalised company that is among the first into a new market; or a well-known trusted brand for a high-profit-margin consumer product.

These attributes cannot be viewed in isolation. A company may be a low-cost producer but not a quality stock if its product line is falling out of favour with customers. Likewise, being the technological leader in a technological field means little without adequate capitalisation for expansion and marketing.

Determining quality in a stock is like reviewing a restaurant. You don't expect it to be 100 per cent perfect, but before it gets three or four stars you want it to be superior.

Templeton's advice is to study companies to learn what makes them successful.

Buy value

Never invest on sentiment. The company that gave you your first job or built the first car you ever owned may be a fine company. But that doesn't mean its stock is a fine investment. Even if the corporation is truly excellent, prices of its shares may be too high.

Never invest solely on a tip. Unfortunately, there is something psychologically compelling about a tip. Its very nature suggests inside information, a way to turn a fast profit.

Templeton rightly said that ultimately, it is individual stocks that determine the market, not vice versa. While investors keep their focus on the market trend or economic outlook, individual stocks can rise in a bear market and fall in a bull market.

The stock market and the economy do not always march in lock step. Bear markets do not always coincide with recessions, and an overall decline in corporate earnings does not always cause a simultaneous decline in stock prices. So, buy individual stocks, not the market trend or economic outlook.

Buy after doing your homework

Investigate before you invest. Study companies to learn what makes them successful. Remember, in most instances, you are buying either earnings or assets. In free-enterprise nations, earnings and assets together are major influences on the price of most stocks.

The earnings on stock market indexes--the fabled Dow Jones Industrials, for example--fluctuate around the replacement book value of the shares of the index. (That's the money it would take to replace the assets of the companies making up the index at today's costs.)

If you expect a company to grow and prosper, you are buying future earnings. You expect that earnings will go up, and because most stocks are valued on future earnings, you can expect the stock price may rise also.

If you expect a company to be acquired or dissolved at a premium over its market price, you may be buying assets.

Buy across

A portfolio must always be diversified--by asset class, by industry, by risk, and by country.

No matter how careful you are, you can neither predict nor control the future. A hurricane or earthquake, a strike at a supplier, an unexpected technological advance by a competitor, or a government-ordered product recall--any one of these can cost a company millions of dollars.

Then, also, what looked like such a well-managed company may turn out to have serious internal problems that weren't apparent when you bought the stock.

A great advocator of global investing, Templeton explains that if you search worldwide, you will find more bargains--and possibly better bargains--than in any single nation.

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Larissa Fernand is the editor of the Morningstar India website, where this article initially appeared.

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