The three cliches that cost you money

THERE'S a terrific quote about conventional wisdom -- conventional wisdom is long on convention and short on wisdom.

THERE'S a terrific quote about conventional wisdom -- conventional wisdom is long on convention and short on wisdom.

This week I received a frightening reminder of just how easy it can be to believe you're investing on sound principles while having the foundations of your life savings balanced on three useless cliches.

An investor called to inquire about the Montgomery Fund. They said they'd been invested elsewhere, were unhappy with their returns over many years and had received the following advice: "Buy blue chips, put them in the bottom drawer and invest for a long time."

The result of this advice is the reason investors have left the stockmarket in droves, stockbrokers are merging and fund managers are bleeding from ever-increasing outflows. Unhappy investors have been acting with their self-managed super funds on these useless principles for decades.

Let me explain why these are not investment principles at all.

The idea of investing in blue chips is as old as the stockmarket itself. But the conventional definition of a blue chip is plain wrong. You have been led to believe that a blue-chip company is one that is large, has been around for a long time and consistently pays dividends.

Sadly, this is not a blue chip at all. Most of the constituents of the ASX 200 meet this criterion, yet many are displaying share prices today that are lower than they were 10 years ago. How can a blue chip produce a negative 10-year return?

A blue chip is, by definition, an extraordinary company. An extraordinary company, by my reckoning, enjoys high rates of return on equity, little or no need for debt and, perhaps most importantly, a rising trend of intrinsic value. As value rises, share prices will follow.

Businesses such as Telstra, Qantas, Boral, National Australia Bank and Leightons have not increased their intrinsic value across the past 10 years. A portfolio of these so-called blue chips would have left an investor deeply disappointed with the stockmarket and their adviser. Real blue chips can be any size and come from any sector and if they're generating extremely high rates of return on equity it is not incumbent on them to pay any dividends at all -- although many do. Companies with rising intrinsic values, high return on equity and little or no debt include Seek, ARB, Carsales and Webjet. Larger companies that meet the grade might be Commonwealth Bank and Woolies.

The next cliche is put your stocks in the bottom drawer.

Australia has a population of just 22 million people and many businesses mature very quickly. Flush with the joys of recently experienced fast growth, boards of directors sometimes turn to dubious practices to extend the period of growth after a business has matured. For example, they make overpriced acquisitions using borrowed funds or dilutive share issues because they have insufficient cash to meet their earnings per share growth targets. But the business's natural limit has been reached and instead managers should simply turn to their investors and admit exactly that.

Investors who leave shares in the bottom drawer may miss the chance to sell for a profit and instead receive a tax-deductible capital loss by hanging around. Lock your bottom drawer before you put anything in it.

Furthermore, share prices can -- and often -- run well ahead of any level that can be justified by the economics of the underlying business.

Once again an investor who leaves shares in the bottom drawer may miss this signal to take advantage of the market's irrational exuberance.

The final cliche, invest for the long term, is a real doozy.

Time is the friend only of an extraordinary business. Time is the enemy of the business that matures and whose economics deteriorates.

Investing for the long term makes sense when you buy great businesses trading at substantial discounts to intrinsic value. The rest of the time "investing for the long term" is advice that means "now leave me alone".

So it's really quite simple: buy great businesses, not chips of any colour, pay attention and only then can you relax for the long term with returns that reflect your wisdom.

Roger Montgomery is the founder of Montgomery Investment Management and the author of Value.able: How to Value the Best Stocks and Buy Them for Less Than They're Worth.

www.rogermontgomery.com