The 5 Secrets to Buying Stocks

Quite a couple of weeks, eh? While not quite the chain of 25-sigma events the folks at Goldman Sachs think they saw, this is the most volatile the stock market's been in five years ... and the exotic hedging techniques we've invented over the past few years don't actually seem to be protecting anyone from anything.

As noted money manager Wally Weitz wrote in a recent shareholder letter, "These are the times that active money managers earn their fees."

Or are they the times that try men's souls?
Still, you don't need to be a professional money manager to start protecting your portfolio against short-term volatility, and positioning it to achieve superior long-term returns. Many of the best money managers, including Wally Weitz, have achieved their fantastic performance without doing anything quite so fancy.

Take Martin Whitman, for example. His Third Avenue Value (TAVFX) fund has crushed the market by more than seven percentage points annually over the past five years, and it's trailed the S&P 500 index just once since 2000.

That's an incredible track record that we'd all be wise to replicate -- and Marty's happy to let us do so. In his last shareholder letter, he revealed five of the key secrets to his success.

In no particular order
To be your own expert money manager, simply:
1. Buy cheap.
2. Buy quality.
3. Buy to hold.
4. Buy with minimal expenses.
5. Buy without leverage.

If you can consistently follow all five of those tenets, you're on your way to making more money in the stock market -- and three of them are so simple that you'd be silly not to be doing them already.

The three easies
"Buy to hold" means sticking with stocks unless, as Whitman writes, "there has occurred a permanent impairment in underlying value" of a stock. Such an impairment would occur, for example, if all 11 of Pfizer's (NYSE: PFE) drugs in late-stage testing were rejected by the FDA, or if Disney (NYSE: DIS) lost a challenge to its Mickey Mouse trademark.

Having the patience and confidence to hold the stocks you buy through inevitable volatility (except when a permanent impairment has occurred) will automatically reduce your tax bill and trading expenses. Do even better by keeping commissions to 1% to 2% of your investments.

Finally, don't invest money you can't afford to lose, and don't borrow money to invest. While leverage can increase your returns in good times, it will dramatically increase your losses in bad times. That's not the way to preserve capital and earn steady returns.

The harder two
Buying cheap and buying quality are more esoteric concepts. Put them together, and Whitman's essentially demanding that we all be smart investors.

But Whitman has a very clear definition of cheap: "Issues at prices that reflect substantial discounts from readily ascertainable NAVs [net asset values] ... [and whose] NAVs will increase by not less than 10% per year compounded." The classic Whitman example here is Brookfield Asset Management (NYSE: BAM), which Whitman bought cheap, and which has returned nearly 45% annually over the past five years.

To find stocks like Brookfield, start with companies such as Time Warner (NYSE: TWX), Bear Stearns (NYSE: BSC), and Sprint Nextel (NYSE: S), which are already trading for low-ish price-to-book multiples, and decide whether they're quality.

Easier said that done?
While "quality" will always be in the eye of the beholder, Whitman's definition is clear. It means having a strong financial position, competent management, and a business that is understandable.

Perhaps that's why Whitman has opened a position in homebuilder MDC Holdings (NYSE: MDC). It's trading for a little more than its book value, but it boasts $668 million in cash and more than 20% insider ownership, and it's poised to weather the real estate downturn. It may also explain why Whitman has steered clear of Bear Stearns, a complicated financial institution that has seen several hedge funds collapse over the past few weeks as a result of links to subprime lending.

Johnny 5 functioning 100%
At our Motley Fool Hidden Gems small-cap investing service, we follow every one of Whitman's tenets; not coincidentally, we share the opinion that MDC Holdings is a "buy." But we focus exclusively on small caps, because we believe they represent one of the few sectors where individual investors can gain an informational advantage over institutional money.

While recent volatility has our small caps often running up or down 10% in a single day, our long-term returns have us more than 30 percentage points ahead of the market on average. That's what happens when you buy cheap, buy quality, and buy to hold.

You can take a look at all our Hidden Gems research and recommendations -- including today's brand-new issue, releasing at 12 noon ET -- by joining the service free for 30 days. Click here for more information.

By Tim Hanson