BI > NOVEMBER 2002

Challenging Your Club's Portfolio -- and One Another

Remember Tax Effects, Rotate Stock Assignments

Q. What is the NAIC Challenge Process?

A. The Challenge Process is a method for deciding which stocks should remain in your portfolio and which ones should be replaced. When you use the Challenge Process, you look at the forecasted total return on all the companies you're currently holding using projections from various sources, such as the Stock Selection Guide, Value Line and other sources. That gives you an idea of which stocks to feed and which ones to weed.

For individual investors, I recommend "challenging" any company that's offering less than a 5 percent total return. If you're in a club, the club needs to come up with a percentage return that members are comfortable with. When you find a stock that isn't meeting your criteria, you run a comparison with other companies in the same industry to see whether there's a better one to replace it with. For example, if you own Merck, you might want to compare it with Pfizer, Abbott Labs and Bristol-Myers Squibb.

Ed Sankey has been a member of various investment clubs, including the Beaver Dam Investment Club and the Waukesha Mutual Investment Club, since 1951. An avid individual investor as well, he now lives in Beaver Dam, Wis., where he and his wife enjoy fishing and a daily tee time. He can be reached at edsankey@powercom.net.

Sometimes it seems like a pretty easy decision, but there's a lot more to trading in one stock for another than first meets the eye. You've got to look at the tax consequences. For example, if you have a holding worth $100,000 and $80,000 of that is profit, you figure in a maximum tax rate of 20 percent, or $16,000, and you've got 84 percent of your original investment left to invest in a new stock. So you can have $84,000 to invest in a new company, or you can leave the $100,000 in the company you already own.

The Challenge Process allows you to do a "spot" comparison. It helps you to answer these questions: Which stock is a hold? Which one offers the highest return? Should I replace what I own with another company in the same industry?

Q. How often should a club use the Challenge Process?

A. A club should know at every meeting what the potential total return on each stock is going to be. That's the time to take a look at your stocks and ask: "Do we want to own these? What has changed since we bought the stock? Has management changed? Have the fundamentals changed?"

Take a look at the portfolio management summaries in Investor's Toolkit 4. You can sort by total return and find out which stocks are giving you the lowest and highest returns. Then club members need to ask whether they can do better. Clubs need to stick with what they know -- and not be afraid to sell or buy more, whatever the case may be.

That said, you also want to be sure you don't make rash decisions. In the club that I belong to, we require that a stock be posted on the agenda as a possible buy or sell. That agenda goes out to all the club members via e-mail the weekend before our Thursday meeting. We can't vote to buy or sell a stock unless it appears on that list.

Q. What is the proper diversification for a club portfolio, and how does the club achieve that?

A. When a stock becomes too big a percentage of the club's portfolio, like 28 to 30 percent, the portfolio gets out of whack. It's time to diversify. I'm against selling winners, but when one stock becomes too high a percentage of the portfolio, you've got to make a decision.

To keep a portfolio balanced, one stock shouldn't make up more than 15 to 20 percent. When a stock doubles, going from, say, 7 percent of the portfolio to 15 percent, you might consider selling part of it and buying more of another company. You wouldn't have to sell all of it. If the gain is horrendously low, like 5 percent or less, club members need to ask why they're holding this stock.

A club's portfolio can also become too diversified. Some clubs continue to buy stocks without ever selling any and wind up with 25-30 companies in a portfolio that's too small to support that kind of number.

For example, if your club portfolio is between $350,000 -- $400,000, I wouldn't recommend having any more than 15 stocks. If your portfolio's total value is less than $100,000, six or seven stocks should be your maximum. You can also base the number of stocks on the number of members, with one stock for each member to follow.

Q. What are some of the biggest mistakes that clubs make?

A. One mistake is that club members fall in love with a stock and don't want to sell it. That happened in the Beaver Dam Investment Club with RPM. We bought it at about $2.55 back in 1970 and enrolled in its dividend reinvestment plan.

One member had fallen in love with it and kept noting the continuing gain in RPM's sales and earnings in his quarterly reports. What he failed to mention was that RPM was nearing our high projected price for it.

By 1997 we felt that RPM wasn't offering very good growth anymore. That was the time to sell some and use the proceeds to buy another company. But by the time the club members decided to do that, the stock had hit a high and gone back down -- and it was a buy again. One way to avoid that kind of an attachment to one company is to rotate the companies in your club's portfolio among your members.

Another big mistake is buying stocks that don't have positive earnings. We're all tempted to do that. At one time, fuel cells looked like they were going to be the thing of the future; energy costs were going up. The club I was in bought two companies in that industry; one did well, the other didn't. But the bottom line is that there's always time to get in on a good company. You don't have to get on the bandwagon and buy right then -- especially when the company isn't even showing positive earnings.

Q. Do investment clubs have any advantages over individual investors?

A. When you're comparing club investing with individual investing, one of the advantages for the club is that the club has the opportunity to gather far more information and to debate the different judgments and numbers that members have come up with. Why make a decision based on one Stock Selection Guide completed by one club member when three or four members could each complete an SSG? Debate the differences in numbers and judgment calls. That's where you get into the real decision making.

When you have each member assigned to follow one stock and the club bases its entire decision on that one SSG, it becomes a contest as to who can come up with the highest numbers. And those numbers can change dramatically with a slight change in the projected price-earnings ratio or projected earnings per share -- a whole number of things. That's where the debate should come in.

Clubs need to take full advantage of what they have: the power of many people working together. That's what it boils down to.