Five key investing rules and a market outlook from a money manager who crushes the market

MarketWatch gives me the great opportunity to regularly interview smart people about the stock market and learn some key investing lessons.

How do I know who the smart players are? After all, the stock market attracts a lot of hucksters, mediocre people, and grifters.

For mutual fund managers, I apply what I call the Morningstar IQ test – outperformance at three and five years. This is a major distinction because beating the market is tough. And this time frame is long enough to assure it’s not just a fluke.

By this measure, Alexander Ely, who manages the Delaware Smid Cap Growth fund (DFCIX), would belong in the Morningstar market “Mensa” club, if there were one.

Ely beats his Morningstar mid-cap growth category and Russell mid cap growth index by about 18 and ten percentage points, annualized, over the past three and five years. That’s rare.

Here are five key investing lessons Ely recently shared with me.

1. Invest in disruptive companies

These are companies that do things better, faster and cheaper. It’s pretty much that simple.

A great thing about disruptive companies is that you can simply hold them for a long time because external events like pandemics and recessions don’t really matter. Their “creative destruction” continues. “We are not going to invest in companies that we don’t think aren’t upending the current ways of doing things,” says Ely.

Examples from his portfolio include Square (SQ), a banking app; Boston Beer (SAM), a leader in the “quality food and drink” disruption trend; NovoCure (NVCR) and iRhythm Technologies (IRTC) which are leaders in the disruptive virtual healthcare trend; and YETI (YETI) and Planet Fitness (PLNT) capitalizing on the outdoor recreation, exercise and healthy living trends.

Historical examples of disrupters are Intel (INTC) and Microsoft (MSFT) when they lead the shift to PCs; Home Depot (HD) and Walmart (WMT) in big box stores; and Nike (NKE), Procter & Gamble (PG) and Coca Cola (KO) in the globalization of U.S. brands.

2. Invest in leaders

You can identify these because they have the largest market share and the best product or service. “You want to own a Facebook (FB) not a Myspace. Alphabet (GOOGL), not Ask Jeeves,” says Ely. As examples, leaders in biotech include Crisper (CRSP) in gene editing, Exact Sciences (EXAS) in medical testing, and InVitae (NVTA) in genetic testing – all names you’ll see in his smid-cap portfolio.

3. Keep risk on a tight leash

A common market adage holds you should sell your losers and let your winners ride. Many people do the opposite, and it hurts them. But Ely doesn’t buy it. He follows strict sell guidelines based on position size and stock price action that have him regularly trimming both winners and losers.

First, the winners. He cuts his winners to keep position size in line, to trim single stock risk. He generally caps position size at 5%. Typically, the big positions are 3.5%-4% of his portfolio. For example, he trimmed Teladoc (TDOC) earlier this year after its giant advance.

On the downside, he begins to trim names if they lag their sector benchmark by 20% for five to ten days. If a name lags by 30%, he sells the whole thing. “If something is wrong and growth is slowing you should move on to something more robust,” he says.

4. Go for growth

Part of Ely’s risk management is to favor high growth companies. “We want something growing significantly faster than the overall economy,” he says. The key gauge here is sales growth, since revenue is harder to fake than earnings. He looks for minimums of 10% annual revenue growth and 20% earnings growth. His smid-cap fund names have 27% revenue growth and 39% income growth, on average.

5. Don’t trade

“The biggest mistake people make is trying to trade,” says Ely. Spend any time on Twitter market threads, and it’s clear that a lot of people are making this mistake. The problem with trading is you are betting you will be right not just with the entry, but also on the exit price — and doing this over and over. It is not easy to be right so often.

Instead of trading, he prefers to own “one decision” names, meaning disruptive companies. “I am trying to hold the best names, and let them work over a long time. Every great growth company has been a leader and major disrupter of an industry.”

Market outlook

Ely thinks this is the best time to invest since the early 1990s. He predicts the market will triple in the next decade. Two reasons.

* First, a new bull market and economic cycle just started, and previous bull markets have lasted around eight years on average.

* Next, visibility on the economy is improving dramatically. The election is (probably) behind us. (There’s still Georgia.) Power in Washington, D.C. will be split between the two parties. That improves visibility by muting the legislative agenda.

The next reason is that vaccines are on the way. “The pandemic will be virtually over in the U.S. by the summer,” predicts Ely. Here’s the upshot: When there’s greater visibility on the future, CEOs and consumers make bigger spending decisions, and that boosts growth. “We expect economic activity to boom in the second half of 2021 and 2022,” he says. Importantly, he thinks a boom in capital spending will boost productivity. That would be key because it will neutralize the inflation risk, a risk because of all the stimulus-induced growth ahead, in my view.

Ely has an obvious bias, but his logic on why smid-caps are one of the best places to be makes sense. Companies of this size are more levered to the economy than giants like Walmart.

You can see the full version of this investment column at MarketWatch here.

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