The worst investment mistake you can make

Falling in love with popular stocks is a mistake that even professional investors make. But they are almost always overbought and overvalued. The way for a private investor to beat the City is to buy stocks trading below their true value. Simon Caufield explains how to find them.

What do you think of Fortune magazine? To me, it's the magazine that rich people read. And what's the most important financial goal for rich people? Of course, it's to stay rich after inflation.

So when, ten years ago on 14 August 2000, Fortune put together a list of "ten stocks to last the decade", it should have been worth reading. The magazine predicted: "a few major trends will likely shape the next ten years. Here's a buy-and-forget portfolio to capitalize on them".

Well, had you bought the portfolio, you would certainly wish to forget about it, as we'll see in a moment. And there's a vital lesson that you can learn from this.

Buy and forget you'll wish you had

The ten stocks tipped by Fortune as "buy and forget" stocks, were Broadcom, Enron, Genentech, Morgan Stanley, Nokia, Nortel, Oracle, Schwab, Univision and Viacom.

And they'd have lost you 70% of your money over the decade, as the chart below shows.

Fortune Magazine's ten stocks to last the decade

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Source: GMO, Bloomberg, Datastream

Now you may think I'm being wise after the event. But the fact is that Fortune fell victim to the worst investment mistake you can make: that is falling in love with growth.

Every one of the ten companies operated in markets with huge potential growth. Wireless communications, broadband, internet equipment, business software, biotechnology and entertainment were set to change the world. Each company was growing sales very fast. Their prospects looked limitless.

The trouble is, every investor on the planet knew it. So the stocks were hugely popular and very expensive. The average price / earnings ratio on 14 August 2000 was 347. So even if they grew profits ten times, it was still going to take them 35 years to repay your investment.

Even professional investors chase expensive stocks

Why does this happen? Well, it starts because human beings aren't programmed to deal with uncertainty. We're naturally overconfident. For example, 82% of us think we are above average drivers. Almost all investors believe their returns will be better than average. I could go on and on.

So when we like a stock, we are certain it's a good buy. That means popular stocks are almost always overbought, and overvalued. They've been on a tear and you think they're going to make you rich. The truth is they're more like lottery tickets lousy investments. But we play because we just can't resist the dream.

Even professional money managers make the same mistake. Their worst nightmare is clients taking away their money. That's how money managers lose their job. So how do they prevent it? They own the same stocks as everyone else. They own the stocks they think you want them to hold. Then there's no reason for a client to switch.

Imagine you are a fund manager trying to explain to your irate investors why you don't own Apple, for example, when it's quadrupled since March 2009. Even if you think it's wildly overvalued, you have to own it. If you don't and then you underperform the market, you're history.

On the other hand, underperform the market by owning the same stocks as everyone else and you'll survive. This is why fund managers think it's OK to lose your money just as long as the other fund managers are doing it too.

The crucial truth that most investors don't get

Professor Ben Graham, the inventor of value investing, never paid for growth. He distrusted growth companies so much that he developed a way to value stocks based on assets and current earnings. He factored in nothing for future growth. And many people me included believe Graham to be the most successful investor ever.

He saw a truth that most investors simply don't get.

Professors Elroy Dimson, Paul Marsh and Mike Staunton at London Business School have now proved what Graham knew. And it's this

Fast-growing companies don't generally deliver better returns than slow-growing ones.

Stocks in fast-growing emerging markets haven't beaten slower-growing developed markets over the long run. It's as if growth has no value. How can this be?

Well, investors forget that growth is not free - growth requires investment. At a bare minimum, a growing company needs more working capital;many will require more space and equipment; and some might need to boost research and development to keep the growth going. These all need investment - and they cost.

So growth is valuable only for a few special companies. They are businesses that reinvest profits to deliver returns that are higher than their cost of capital. And these types of companies attract competition. Just look at the huge number of electronics companies rushing to bring out tablet computers to compete against the Apple iPad.

Only companies that can defend their markets against competition are able to maintain profit margins and growth in the long run. And that's rare. In the last ten years, the world leader in mobile phones has changed from Motorola to Nokia to Research in Motion (Blackberry) to Apple. Every time someone brings out a better phone, customers switch. Do you really think Apple is going to be able to keep bringing out better phones than the competition for ever?

The best way for a private investor to beat the City

So be very careful about growth. Companies like Apple, Arm Holdings, Amazon and Netflix may be great companies, but at current prices, they're almost certainly not great stocks. They're just too expensive. They're lottery tickets.

Instead you need to be looking for the exact opposite of a lottery ticket. And what's that? It's a stock trading at below its true value.

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In fact, I feel strongly that you should be able to easily beat the City professionals using this strategy. And I'd like to show you how.

I've written three free reports onThree Simple Rules to Successful Investing. I'd be delighted if you read them, and I think you'll find them very interesting. They're free and yours to keep. My first report, Always Buy Ugly, is available here and you can read it right now.

And in the next few weeks I'll be telling you all about a stock which I believe fits the bill perfectly.

This article originally stated that the Fortune list of stocks was published in 2001. However, it was published in 2000. This has now been amended.

This article is taken from our free daily email, Money Morning. Sign up to Money Morning here to receive intelligent investment advice every weekday.

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