(05/02/13) Top Picks from Keen-Eyed Investors

Ken Kam's Marketocracy Masters have enviable track records. Here are their latest recommendations.

Nancy Zambell: My guest today is Ken Kam, the CEO of Marketocracy and also a portfolio manager. Ken, thanks so much for joining me. I appreciate your time.

Ken Kam: Thanks, Nancy. It's always a pleasure to be with you.

Nancy Zambell: Tell us a little bit about your Marketocracy Web site and your Marketocracy Masters. Some of them have been at it for quite some time, choosing stocks and portfolios.

Ken Kam: I started Marketocracy to find people who have a proven track record as investors.

It is hard to believe, but in an industry as performance and method-driven as the investment industry, it is very hard to find people who have a track record that they can call their own that is long enough and convincing enough to be confident that the person that you are trusting with your money actually has some skill. In fact, it takes years for an investor to prove themselves.

So on our Web site, I make people manage model portfolios for at least five years. And I monitor the performance of the models, because until they have proven themselves, I don't want to give them any client that's managed.

The only ones that I even interview are those who after five years have outperformed the market by at least 1,000 basis points a year, on average. I think that that is enough of an extra return over and above the market to warrant an interview to figure out how they did it.

It's only the ones that pass both the quantitative tests and the interview process-so that I understand how they work-who become the masters of Marketocracy. And they are the ones that I assign to clients as money managers.

Nancy Zambell: How many of those do you have right now, Ken?

Ken Kam: Well, it takes five years and you have to perform really well to do it, so I didn't expect that there would be thousands of people like this.

Over the course of the last ten years, we have identified a good dozen, and every year that goes by we find a few more. I think we are finding a lot of people who look at investing with passion and who have, over time, demonstrated the track record that makes clients feel comfortable asking them for advice.

Nancy Zambell: Do some of them specialize in certain asset classes or market capitalizations, or are their portfolios pretty much diversified?

Ken Kam: No, I can say with some confidence now that the way you get to be a great investor is focusing on a sector or a style of investing. There is no one that is good at everything.

You can compare these investors against the five market indexes. It is almost an unfair comparison, because broad market indexing means you have to make investments in a different style.

Since no one is really good at that-at everything-I think that the key here is to identify what it is that they are good at, and compare them against the right benchmark, to know if they're up higher than the benchmark. The bond market is hardly ever the right benchmark.

Nancy Zambell: That makes a lot of sense. Tell me: there are several sectors that I know that you are interested in and that have been doing very well for you. Refiners for one. Is that correct?

Ken Kam: Yes it is. It is doing pretty well for the last year. It has taken a little bit of a hit in the last month because of new regulations that the EPA is proposing, but we think that the weakness is going to be short-lived. So we are recommending that people take advantage of this dip to put more money into stocks.

Nancy Zambell: What stocks do you like in that sector?

Ken Kam: My favorite one is Marathon Petroleum (MPC). We also like Phillips Petroleum (PSX). The reason why these two companies are our favorites is because they are able to take advantage of the price differential between Brent Crude and West Texas Intermediate.

People who follow the industry are aware of what is happening in the natural gas industry because of the fracking. What people don't see is that the fracking also increases production of crude oil. There is a lot of crude oil around certain areas that began fracking.

If you have your refiners in those areas, that means that you can pay less for your feed stock than everybody else and get the same price for the gasoline that you produce at the end. That means you get higher margins, and that is what has been driving the economy. Marathon Petroleum, for example, is up almost 100% over the last 12 months.

Nancy Zambell: That's pretty decent.

Ken Kam: It's a pretty decent return. It is down about 10% over the past month, but this fracking is not going to go away. We see the extra margins that they have been able to book for the past year. It is not a short-term debt.

Nancy Zambell: Do those companies pay dividends, Ken?

Ken Kam: Yes, they do. In fact, the average dividend you get here is somewhere between 2% and 3%. It's compares pretty favorably to any money market account or bank account.

It's not the best place to go for dividends, but once you get a 3% yield and have the potential to make 50% to 60% capital gains in a year, that is a good risk-reward profile.

Nancy Zambell: That's really healthy. Speaking of higher dividends, some of the mortgage REITs have been paying some pretty decent dividends. Are you involved in any of those?

Ken Kam: This is a different Marketocracy master who is following those. Some of these mortgage REITs that he is following are yielding upward of 16% a year.

The one in particular that is his favorite is American Capital Agency (AGNC). These companies in general-and this one in particular-invest only in government-guaranteed mortgages. The principal risk of their investment portfolio is pretty much nonexistent.

They are big enough that they can borrow money on the public markets for next to nothing because Bernanke has seen fit to keep the interest rates close to zero. They invest in mortgages that have a good yield, so that they can pay out the 16% dividend yield, and it still appreciates. I think over the last three years, the average annual return for that stock is north of 20%.

Nancy Zambell: That is hard to find.

Ken Kam: That's hard to find. You get a lot of it in dividend, and you get extra in capital gains. For an equity portfolio, a 16% return a year would be considered a good return. With this stock, you've got dividends, and as long as interest rates stay low, there is still the chance for an additional capital gain on top of that.

Nancy Zambell: Another sector within the real estate market that has done very well have been the homebuilders. Are you involved with any of those?

Ken Kam: Yes, and that's an even different person. Remember, I said earlier that the way that you get to be a great investor is by focusing on a single sector or style.

The homebuilders are a different kind of investor than mortgage REITs or the refiners. You wouldn't expect the same person to be good at all of that.

The competition among homebuilders has diminished greatly, since the only people who get funding to develop homes anymore are the national homebuilders. All of the regional homebuilders that used to bring them competition, and keep their margins industry-wide low, have gone out of business over the last five years. And the ones that are left aren't big enough to go to the capital markets for financing. They can't get their projects completed.

The big ones such as D.R. Horton (DHI) operate in areas that are experiencing an energy boost because of fracking advances. They are able to borrow money cheap to finance their projects, and they have less competition than they did five years ago. Those companies also pay 2% to 3% dividends.

I would say this about the homebuilders: The national ones are the ones that you want to focus on, but not all of the national ones.

The ones that are the most attractive are the ones that are operating in the areas that are experiencing an energy boom, because that is where housing prices are rising the most. D. R. Horton is in the Texas area, where there is a lot of fracking going on. That has been an historic energy state, but I also like the East Coast or Oklahoma. I would be looking at national homebuilders that have big projects.

Nancy Zambell: Let's switch over to technology. Are you doing anything in technology these days?

Ken Kam: Actually, in technology the area that I like best is biotechnology. Not chips, but drugs.

There are advances that have been made in the past few years that are only now coming to market, and those companies are making a transition from being an R&D-driven company to producing drugs. That is a tough transition to make. Oftentimes, it requires a change in the top management.

Any person who knows how to sell can sell the product, but those are also the least risky part of the companies' life cycles, because there are a lot more people who can manage manufacturing products and sales than who can develop a new drug.

Once the drug is approved by the FDA, the regulatory risk and the efficacy is known and published. Now you are dealing with just locking in and handling risk like every pharmaceutical company faces. And this is when it starts to produce numbers that most of Wall Street looks for-revenues and earnings. Until then, the income statement on the balance sheet and balance sheet would show you nothing.

Nancy Zambell: Do you have a favorite in that arena?

Ken Kam: I think that my highest confident stock in this area is Amarin (AMRN). They got approval for their drug last year. It took them nearly a year to get the sales force set up and start to roll it out. I think that this is a four- or five-bagger in the next couple of years.

Nancy Zambell: What kind of symptoms or diseases do they treat?

Ken Kam: Amarin's drug is useful for patients who have high triglycerides. It often happens that if you have triglycerides, you also have high cholesterol.

The problem with this is that the one drug that you would take to reduce your triglycerides happens to increase cholesterol. So that is not that good. And it really significantly narrows the market for that drug...and yet it still sells over $1 billion a year for GlaxoSmithKline (GSK).

Amarin's drug can lower your triglycerides without increasing your cholesterol level. I think that at a minimum, they are going to go over the market share for GlaxoSmithKline's drug, and that's going to generate $1 billion a year for them.

It is also going to expand the market, because a lot of people have high triglycerides and high cholesterol, and for that reason they can't take the other drug. But they could take this one.

Nancy Zambell: That sounds like a really good return, four- to five-bagger. We can all take that, right?

Ken Kam: We can all take that. And in the context of a diversified portfolio where you are betting on all of these segments with people who have proven track records in their area, I think that it is a successful way to go after great returns without taking on excess risk.