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Faith Based Investing

In general, I am a big fan of buying shares of companies you know something about.

When mutual funds got their second wind in the late 1980s, they democratized American investing. Just 6% of U.S. households owned funds in 1980. The figure was 48% by 2005.

The typical stock mutual fund is a portfolio of about 100 companies, managed by a professional and backed by a research staff. Broad diversification reduces risk, providing what Harvard economist John Campbell calls "a free lunch." And the cost for the stock picking and record keeping is pretty reasonable -- on average, about $1.25 for every $100 invested annually. For nearly all investors, mutual funds make good sense. But many financial planners go too far when they admonish clients to own mutual funds exclusively. There are excellent reasons to own plain old individual stocks as well.

Serious money. Mutual funds have two big drawbacks. First, the fund manager makes decisions, such as taking copious capital gains, that can have a major effect on your tax bill. Second, mutual fund fees mount steeply over time. Take Fidelity Contrafund, which has relatively low annual expenses (0.92%) and no sales fee. If you invested $10,000 in the fund, and it returns an average of 10% annually, at the end of ten years you'd have paid $1,453 in expenses -- or nearly 15% of your original cost. It's not hard to find stock commissions of $50 or less for a round trip.

But a more important reason to invest in stocks is that you have a chance to make some serious money doing it. No doubt diversification diminishes risk, but it also reduces profits. Over a long period of time, investing in a broad-based mutual fund will produce returns that are roughly the same as the stock market as a whole. If history is a guide, those returns won't be chicken feed -- about 9% annually after expenses -- but they're unlikely to be a feast.

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Consider a hot sector: energy. Over the three years that ended March 1, Vanguard Energy fund returned 178%. Nice. But many individual energy stocks have run circles around Vanguard Energy and all the other energy-sector funds. For example, Southwestern Energy (symbol SWN) returned 997%, and it is by no means the top- performing energy stock.

The way to make money in the stock market is to make relatively large investments in a relatively small number of stocks. This approach is the opposite of what most people are taught, but some of the best financial minds believe in concentration. Warren Buffett is fond of quoting bawdy Mae West: "Too much of a good thing can be wonderful." His philosophy in running Berkshire Hathaway (BRK/A) is simply to buy good companies at good prices, not to maintain a balanced or widely varied portfolio. "Diversification," says Buffett, "is a protection against ignorance. It makes very little sense for those who know what they are doing."

John Maynard Keynes, the most influential economist of the 20th century and a highly successful investor in his own right, wrote, "As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes."

Special confidence. Keynes calls the motivation for making such large investments "special confidence." I like that phrase. It connotes faith-based, or love-based, investing. Dividing your affections among too many stocks is what Peter Lynch, former manager of Fidelity Magellan fund, calls "diworseification." Lynch is considered by some to be the best fund manager of all time, and he attributes his success not to finding stocks that gain a bit more than the broad market each year -- or knocking out singles -- but to hitting what he calls "ten-baggers," that is, stocks that return ten times his original investment. "You don't need a lot in your lifetime," said Lynch.

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How do you find the ten-baggers? Sometimes the best place to look is your own backyard. One of my favorite stock pickers, Elliott Schlang, practices this philosophy at his firm, Great Lakes Review, which sells research to large institutions, including mutual funds. Schlang is based in Cleveland and concentrates only on companies he can easily visit.

Here's what Schlang likes for 2006: Alberto-Culver (ACV), based in Melrose Park, Ill., a beauty-care company that's been compounding its dividend at an annual average rate of 18% over the past five years; Education Management (EDMC), in Pittsburgh, a fast-growing operator of 72 schools specializing in design, business and health sciences; RC2 (RCRC), in Oak Brook, Ill., a maker of toys and collectibles; Mine Safety Appliances (MSA), in Pittsburgh, a maker of homeland-security equipment, such as handheld gas-detection instruments; Thor Industries (THO), in Jackson Center, Ohio, a manufacturer of recreational vehicles, with a spectacular return of 51% on invested capital last year; and Applied Industrial Technologies (AIT), in Cleveland, the largest independent distributor of industrial products in North America.

Schlang and his researchers spend a lot of time examining company books, talking to competitors and doing site tours. But he also tells me that "for some of my own investments, I don't know a damn thing about the business, but I know the people who run them and bet on those people." He cites Cleveland-Cliffs (CLF), a maker of ore pellets, which has been a nine-bagger over the past three years.

Schlang was at a Harvard Business School reunion not too long ago when the chief executive of Novartis spoke. "I was tremendously impressed and went out and bought the stock," Schlang says, referring to the Swiss pharmaceutical company.

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Of course, there are dangers to relying on impressive executives. Ken Lay, of Enron, was a persuasive fellow, and someone less experienced than Schlang might have run out and bought that stock, too.

A matter of trust. But, in general, I am a big fan of buying shares of companies you personally know something about -- or ones that have top managers you trust. I've found all of my own big winners this way, including a New Orleans-based bank holding company called First Commerce, which was bought out by Bank One in 1997. I knew the CEO, understood what he was trying to do and had an informed faith in his ability to succeed. Similarly, I scored a four-bagger in Apollo Group (APOL), a for-profit education company, about a year after interviewing its charismatic founder. More recently, I invested in Gilead Sciences (GILD), a biopharmaceutical company, after doing a bit of bonding with the firm's CEO on a rugged trip to Africa. None of these executives gave me inside tips, of course. I was attracted to their integrity, vision and leadership.

Meeting up with CEOs is unusual, I'll admit, but, as Yogi Berra said, "You can see a lot just by observing." I scored a three-bagger with Starbucks (SBUX), buying it after I noticed a long line of average Americans queuing up for $3 coffee -- and taking a pass on the 99-cent Maxwell House -- at a rest stop on Interstate 95. Last year, I bought stock in Wynn Resorts (WYNN) after staying in Steve Wynn's brilliantly run hotel-casino in Las Vegas. And I own Whole Foods Market (WFMI) and Apple Computer (AAPL), both two-baggers in two years, because I adore the products. (Stocks that I would still recommend are bold-faced.)

Your comfort zone. When it comes to stocks, about 40% of my assets are currently in mutual funds and ETFs and about 60% in individual stocks. You don't have to adopt the same proportions. In fact, if you have no time to study stocks or you worry too much about the added risk, keep all your money in funds. But if you do have the inclination and enjoy the chase, real live stocks are the place to be.