If you’re new to Money Morning we’d forgive you for thinking we’re a conservative no-risk investor.
After all, we’ve spent a bunch of time advising you to make sure you’ve got plenty of cash and that you own good quality dividend-paying shares.
So we get it if you think we avoid risk at all costs.
But nothing could be further from the truth…
We encourage every investor to have a sound base to their investments.
Building a house is a good analogy. Everyone knows that it’s important to build a house on solid foundations. There’s no point installing fancy fixtures and fittings and kitting the place out nicely if you’ve scrimped on the foundations and the main structure.
The first gust of wind (as we’ve had in Melbourne over the weekend) will see the house collapse in a heap.
Likewise in investing, if you put all your money in high-risk investments without building a sound structure, the first gust of financial wind (as we’ve had in the world economy for the past five years) will see your portfolio collapse in a heap.
But by the same token, if you think investing is all about keeping things safe and not taking risks – just like Warren Buffett doesn’t take risks – then you’re making a huge mistake…and you’ve got little understanding of how Buffett makes money…
To show you what we mean, take this report from Investmentnews.com:
‘Berkshire Hathaway Inc. (BRK/A) said second-quarter profit climbed 46 percent on Chairman Warren Buffett’s derivative bets and gains at the company’s railroad…
‘Buffett’s derivative bets on stock market gains boosted earnings by $390 million in the second quarter…‘
Sure, Buffett and his investment firm Berkshire Hathaway [NYSE: BRK/A] make a lot of money from railways, banks, consumer products, and other businesses.
But his investment strategy isn’t just about buying American Express [NYSE: AXP] and Coca Cola [NYSE: KO] shares and then collecting a tasty dividend.
Some of Berkshire Hathaway’s biggest gains in recent years have come from derivatives…especially the derivatives contracts entered into by Berkshire’s insurance companies.
But as the report from Investmentnews.com explains, nearly 10% of the gains came from potentially risky derivatives bets. That hardly fits in with the well-managed image of ‘uncle’ Warren, the sensible old-time investor who enjoys cheeseburgers and Cherry Coke.
And we’re not knocking Buffett for making these bets. In fact, we believe all investors should have a higher risk component to their portfolio. Buffett’s investment strategy involves placing big derivatives bets. We prefer small-cap stocks…
Now, it’s important to note that there isn’t a direct comparison between Buffett’s punt (selling put options to earn a premium) and our preference of using small-cap stocks.
Each has a different risk and reward profile. We won’t go into the details on selling put options. If we did these notes would have to be about five times as long as normal.
All we’ll say is that most investors who like to think of themselves as Buffett disciples assume they should only buy the safest and bluest of the blue-chip companies.
That’s true to some degree. But it doesn’t paint the correct picture on how Buffett helps boost Berkshire Hathaway’s profits.
If you really want to improve your investment returns and build a lasting investment portfolio, you’ve got to add a level of risk to your portfolio. As we say, our preference is small-cap stocks.
We like small-caps for the simple reason that unlike some derivative investments, with a small-cap stock you’re still investing in the business. You’re not taking an interest in the performance of an underlying stock (such as with CFDs). And the calculation of your returns doesn’t depend on complex mathematical formulas (such as with exchange traded options).
With small-cap stocks you simply buy into a company and perhaps a sector that has the potential to achieve out-sized returns compared to blue-chip stocks. It’s a strategy we’ve used over the past year to bet on the dividend rally.
We selected a small number of stocks we believe can deliver capital growth, pay a dividend, and grow that dividend. It’s the ‘Holy Trinity’ of investing if you like.
Our bet is those small-cap income stocks can grow their businesses and dividends faster than blue-chip income stocks. So far things are going to plan, but the bigger payoff won’t happen overnight. In some cases it could take a couple of years or more before the stock and dividend growth really take off.
For more immediate gains, we’re setting our sights elsewhere. We’re looking at the most unloved of Aussie stock sectors – the resource sector.
It’s a risky strategy because no one likes resource stocks today. But that’s exactly the reason we’re backing the sector. We’re not saying a new resource bull run is about to happen. We’re simply saying that investors have priced the resource sector as though no one will ever dig a single gram of ore from the ground.
That’s just crazy. And some brave investors appear to agree; we’ve already seen a small bounce. But if we’re right, even bigger gains are on the way.
In short, watch Aussie resource stocks for the rest of this year. It could be the Aussie market’s best performing sector.
Cheers,
Kris+
From the Port Phillip Publishing Library
Special Report: Make the Chinese Pay For Your Retirement
Daily Reckoning: Good News is Bad News for the Stock Market
Money Morning: Technology and The Future of Money and Banking
Pursuit of Happiness: The Next Big Leap for Transportation Technology
Australian Small-Cap Investigator:
How to Make Big Money from Small-Cap Stocks