One big reason to AVOID great companies

When you think about it, investing is actually wonderfully simple: find a bunch of great companies that are likely to keep increasing their revenues and profits going forward. Buy a slice of each. If they offer the prospect of a solid dividend stream, even better. Receive, re-invest, repeat. Then hold for the long term. 

The only problem, however, is that great companies don't always make for great investments. Confused? Let me explain.

Do your shares do this?

Investing in a business only makes sense if you believe it will outperform the market over a specific period of time. According to former Old Mutual fund manager Ashton Bradbury -- one of 64contributors to Harriman's New Book of Investing Rules -- this outperformance will come from at least one of the following:

  • The company will grow profits faster than the market for a long period.
  • The company is about to be positively re-rated by the market.
  • The company is likely to deliver a positive surprise to the market in the future, perhaps by reporting higher than expected profits.

Look at your portfolio. Does each of your stocks satisfy one or more of the above? If so, you stand a decent chance of making good money. If not, you're increasing your risk unnecessarily by owning them. This matters a lot, particularly when markets are already looking rather expensive.

According to Bradbury, it doesn't matter if your company possesses an enviable portfolio of brands, huge market share and/or massive geographical reach -- qualities that even those who don't invest would probably regard as characteristics of a great company. If it isn't likely to outperform, it's probably not worth owning. Investors would be better served, he suggests, by moving their capital into an index tracker.

It's a convincing argument. In addition to their low charges, index trackers (and exchange-traded funds) give investors immediate diversification, thus eliminating stock-specific risk. The value of a portfolio could still fall, of course, but not to the same extent as one concentrated in only a small number of holdings. Thanks to spreading their cash among hundreds/thousands of stocks, those choosing the former would never suffer the falls recently experienced by holders of funeral services provider Dignity, floor coverings and beds retailer Carpetright or, dare I say it, Carillion. On top of this, passive investments pay dividends that do not depend on the health or performance of any one company.

This is not to say that attempting to build a portfolio of the best companies you can find is a waste of time as we're huge fans of stock picking at the Fool. That said, it's important to remember that your work as an investor has only just begun when you make a purchase. The investment should then be reviewed at regular intervals to ascertain whether outperformance is still likely. Has the true value of a company now been recognised by the market? If so, why retain its shares? Can a highly rated stock continue to surprise or is profit growth now likely to slow?

So as we enter another week in the markets, begin questioning whether the stocks you already own or intend to buy will really beat the benchmark. If not, your money could probably be put to better use elsewhere.

Looking for outperformance? Go small

Thanks to their nimbleness and ability to grow revenues and profits at a faster rate, small-cap stocks have been found to consistently outperform larger peers over the long term, albeit with increased volatility.

If this grabs your attention, don't leave before downloading a special report from the Fool's Head of UK Investing. Marks Rogers thinks he's found a great opportunity in the form of a market minnow that appears to be flying under many investors' radars.

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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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