Steps

Before you do anything

Understand and be comfortable with these things:

• The pros and cons of portfolio concentration.
• How M1 automated investing works.
• How Morningstar analyzes and rates companies. (PDF)

What you need to get started

• Money to invest.
• Investment account.
• Morningstar analyst reports and stock screener.

Money to invest

You need money to make money. The more the merrier. And even more importantly, the more regular contributions the merrier. Although the review of holdings only occurs quarterly, it’s preferable to set up regular contributions as often as comfortable within your budget.

Investment account

I recommend M1 Finance (referral link) because of the automation. You can set up periodic transfers to the account from your bank. You can choose how much cash to hold outside of the pie (or even none). Any cash over the threshold will automatically be invested in the pie and distributed according to the target slice percentages. Once you set it up, you don’t have to do much other than check in on the 3M screen every few months and maybe remove some slices once in a while. You could also recreate something with other discount brokers like Schwab (where I keep other investment accounts), but it will take some manual work.

Morningstar analyst reports and stock screener

This is the not-so-secret sauce of the starry-eyed system. If you don’t have some level of confidence in the plausibility of the Morningstar analysis of equities, this system won’t work for you. My hypothesis is that by limiting the screen to quality on sale using the “3M factors,” I can tilt the odds in my favor with a concentrated strategy that doesn’t require living a double life or completely handing my portfolio over to another human or a robot. Access to Morningstar data may be available through your library or a discount broker like Schwab if you already have an account. I will post the results of the quarterly screen in the blog.

How it works

The basic steps

1. Run the 3M screen.
2. Adjust pie slices.
3. Enjoy life.
4. Repeat steps 1–3 quarterly.
5. Reset pie annually.

1. Run the 3M screen.

This is the screen using Morningstar analyst data. I also limit the results to U.S. companies, but you can optionally include international/ADR companies as well.

• Morningstar Rating (Margin): 4 or 5 stars
• Morningstar Stewardship (Management): Exemplary
• Morningstar Moat: Narrow or wide

2. Adjust pie slices.

This assumes you’re holding about 20 companies in your pie. (See Q&A.)

When buying new companies:

• If the star rating is 5, set the pie slice percentage to 5.
• If the star rating is 4, set the pie slice percentage to 4.

When adjusting existing companies:

• Change the pie slice percentage to match the corresponding star rating. (For example, if a company changes from 4 stars to 3 stars after a quarterly check-in, change the company slice to 3%.)
• To get to 100% more easily, you may want to add a “cash” slice to handle extra space in the pie. I use SCHO, a short-term treasuries ETF.

3. Enjoy life.

• Take a deep breath and relax.
• Don’t look at stock quotes everyday.
• Don’t check your portfolio more than once a week.
• Don’t worry about day-to-day market moves or financial moves.
• Don’t get news or “trade” alerts on your phone.

4. Repeat steps 1–3 quarterly.

• The typical end dates for fiscal quarters are March 31, June 30, September 30, and December 31.
• Companies will typically release quarterly earnings within a month after these dates.
• Don’t worry about the specific date too much, but keep in mind that an earnings announcement may affect the star rating.
• I aim to make adjustments between 2 and 3 weeks after end of quarter dates. (For example, I’ll make adjustments after Q3 between 10/15 and 10/31.)
• Read (or re-read) the Morningstar analyst reports for all your holdings.

5. Reset pie annually.

• Once a year (when ever the quarter you started in rolls around again), revisit the screen as you would in any quarter but with a few additional considerations:
  • If a company has moved to 1 star, you can decide whether you want to keep it and reduce the slice to 1% or sell it.
  • If a company is still hanging out at 5 stars, dig in a little to what the prospects are for the next couple years. Are there headwinds facing the company? The sector? Are the moat and management still in tact? But keep in mind, you should try to give companies at least a three-year time window from when you add them to your holdings.
  • If a company has lost the moat or management rating, consider whether it’s time to let it go.
• Some of these decisions depend on how many holdings you currently have and whether there are new companies coming up in the screen to consider.
• In general, you want to end up with a pie of about 20 holdings that either meet the 3M criteria or started there and have begun to unlock value.
  • At this annual check-in, you also want to be comfortable with where things are for the next year so you’re not unnecessarily selling during the quarterly check-ins.

When to throw in the towel

If you try this system for 5 years and your returns are seriously lagging the benchmark, scrape it and try something else. Results are not guaranteed. You are responsible for your own decisions.