Valuegrowth Investing

by Glen Arnold

The Devil Made Me Do It should not be your excuse after making these common investing mistakes...

1. Don't trust the crystal ball gazers

• Macro economic forecasts... A tremendous amount of time and energy can be saved by not trying to forecast GDP growth, unemployment statistics, purchasing managers' confidence levels and so on. Every day the newspapers are full of discussions on the next move in inflation, interest rates or currencies - much of it contradictory. The value investor should read the headline and move on. The latest statement from the Federal reserve or a report from an economic forecaster at a prestigious investment bank should be given less than ten seconds of your time. Guesses about the future of the economy are largely irrelevant to the investor who is focused on company analysis. Intrinsic value is determined by the owner earnings generated over a number of economic cycles. Whether GDP rises by 3% or falls by 1% in the next year has little impact on this calculation. And besides, forecasts are notoriously unreliable.

• Market timing... Attempting to time purchases and sales to coincide with market highs and lows is wasteful. Unless you are exceptionally clever, and most famous value investors admit they are not, you will not be able to consistently call market tops and bottoms. You are likely to be pessimistic and optimistic at precisely the wrong times. Furthermore, buying and selling on the basis of a prediction of short-term market trends can be very expensive in terms of brokers' fees and buy/sell spreads. The great value investors, with scores of years of experience insist that they cannot predict short-term movements. Why do people with a fraction of the experience of Buffett or Neff believe they can tell you where the market is headed next? These people are everywhere: on the TV, at brokerage houses, in the newspapers. Ignore them all. They display a dangerous combination of supreme confidence and profound ignorance. They are people that don't have a clue but are paid to have a view.

• Chartism and technical analysis... Do not look to price wiggles and other trend data to guide you. The great investors and academic researchers agree that you cannot, with any useful degree of regularity, outperform the stock market indexes by exploiting a perceived pattern in the statistical record. Past movements are of little relevance to the future.

• Short-term selectivity... Buying shares on the strength of the corporation's or the industry's near-term business prospects - say, earnings over the next quarter of half-year - is a pointless exercise and does not deserve to be termed security analysis. There are three potential problems... (1) analysts' fallibility means that the forecast can be wrong, and frequently are, (2) even if the forecast is correct, the good prospects may already be reflected in the stock price, and (3) the market behaves in strange ways and the price may not move the way is rationally should.

2. Don't touch these types of companies

• Hot stocks receiving lots of publicity... The hottest stocks in the hottest industry receive vast amounts of favorable publicity. The result is sky-high share prices and price-earnings (PE) ratios, often supported by nothing more than hope and thin air.

• Technology stocks... This is an optional don't. If you have particular knowledge of a technology and think you could analyze the strength of a business franchise in a rapidly changing technological environment, and assess the ability of a hi-tech managerial team to lead the company to long-term success, then you are entitled to ignore this don't. For those of us that don't know our DNA from our Megabyte Ram, it is best if we don't try to pretend we can understand a technological industry. Analyzing companies at the cutting edge of science is especially difficult. Stay with your circle of competence, and be honest about its boundaries.

• Companies lacking a profit history or start ups... Companies that are full of promises of future profits but lack solid evidence of actual profits should be shunned. It is impossible to assess the durability of the competitive advantage or the strength of the management of such firms. Often these are companies in industries in a constant state of flux. Investors are being enticed to fantasize about what might be. This is not a rational basis for investment with the principle of margin of safety at heart. There are too many imponderables and the chance of error is too great. Why take unreasoned risks when you could devote this energy to the analysis of stocks that do meet the criteria of a value investor?

• Turnaround stocks... For many years Buffett tried buying companies that had fallen on hard times in the hope that they could be turned around. After repeated failure he concluded that the struggle was generally in vain as turnarounds seldom turn.

• New issue stocks (IPOs)... Initial public offerings are generally fully priced. Bargains are few and far between in the primary market; richer pickings are available in the secondary market.

3. Don't manage your portfolio conventionally

• Playing the 'in-and-out' game... Many investors have a tendency to churn their portfolio in a belief that they can take advantage of short-term price movements. Investors simply cannot profit from financial flip-flopping over the long run. Continually fiddling with the portfolio means that the investor (or, more properly entitled, speculator) does not become acquainted with the underlying businesses. In addition, he or she faces high transaction costs. Thousands of day traders have discovered that even if they were lucky enough to throw four sizes in a row the fifth throw of the dice brought disaster.

• Pulling the flowers and watering the weeds... Some investors seem to believe that it makes sense to automatically sell stocks that have risen in price, but hold on to those that have fallen. The maxim that 'you can't go broke taking a profit' is a foolish premise on which to sell a good company's stock. By selling when it has doubled you may miss out on the greatest part of its capital appreciation. A good stock can rise 10- or 20-fold in value. Especially silly is the tendency to hold on to a poor stock because you are afraid of crystallizing a loss. If the company fails to meet the value and growth criteria you set after purchase then the mistake should be admitted and the attempt to 'at least come out even' be abandoned. Money, thus released, can be invested in a good company.

• Stop-loss orders or mechanical selling rules... Selling automatically based on a pre-set trigger price is illogical. Just because the market, in its manic-depressive way, has caused your stock to fall from your buying price you should not automatically sell. If your analysis is sound then you should be a more enthusiastic buyer, not a seller, at the lower price.

• Simple contrarianism... Naive contrarians are always zigging when the market is zagging. Such knee-jerk contrarians, who seem to bask in the warmth of just being different, are being as foolish as those that always follow the crowd. The true contrarian may take a different view to the generality of investors based on thorough analysis. Often, however, the value investor's conclusions will agree with the market consensus, or, at least, not disagree sufficiently to provide a margin of safety.

• Accepting consensus optimism or pessimism... Periodically the market gets carried away with optimism or pessimism. The herd of investors overreact, pushing up the price of a favored stock to irrational levels, while selling or ignoring stocks with intrinsic value much higher than the current price. At the top of bull markets vast numbers of stocks become the object of over-excitement. Speculation runs riot and people who, in normal circumstances behave as investors morph into speculators. Even Graham and Fisher seemed unable to resist the temptation to play the market for short-term gains in 1928-9 (although Buffett did admirably resisted the Great Bubble of the late 1990s). At times of market exuberance stock pickers seem to have an infinite capacity to believe in something good. On the other hand there are times when bad news becomes over represented in stock prices. The mood of investors can become so downbeat that even good news is ignored or spun into bad news.

4. Don't make investment too difficult

• Don't use equations with Greek letters in them... None of the great value investors through history made use of modern financial theory constructs such as the capital asset pricing model with its beta or portfolio theory. And these are relatively simple models being produced by business schools. Financial academic journals are full of complex mathematics that attempt to explain market behavior, provide tools for valuation, or to understand and reduce risk. All of this is rejected as ephemera by the practitioners who rely on much simpler methods of value investing. And yet, these investors are highly successful.
  
  That's all very well, say the financial economists 'perhaps it does work in practice, but it'll never work in theory!' Could it be that great value investors like Graham, Buffett, Fisher Neff, Miller and Lynch were all lucky rather than that the stock market is (at least occasionally) inefficient in terms of pricing businesses, and this inefficiency is exploitable by those with superior techniques and judgement (and courage)? Is it that the complex models will prove, in the end, to possess the truly valuable insights while the personal experiences and accumulated knowledge of the practitioners turns out to be of limited applicability? Perhaps. But I know whose judgement I trust, especially having discussed with university students over many years the difficulties of many of these academic models.
  
  It would seem that modern complex financial models sometimes allow you to perform average. To outperform, it is necessary to invest in undervalued businesses that you understand rather than in shares with particular correlation coefficients and covariances. Complex behavior is not rewarded more than simple behavior.

• Don't use derivatives... Derivatives are an expensive way of reducing risk. The value investor knows that risk is reduced through a thorough understanding of the business, not by using hedging instruments. As for the use of derivatives for leveraging-up returns; this is gambling and should not be considered by an investor in business.

• Don't continually try to go for home runs... Most of us are not brilliant at baseball. We have to add to the score by going for a series of base hits. Don't expect to find a series of spectacular winning stocks. Be consistent, persistent and patient. Stretching yourself to try and make extraordinary high gains can result in disaster. Be reasonable in your goals.

• Don't confine yourself to high liquidity stocks... There are many bargains to be had in stocks that have a low market turnover. Many institutions ignore these stocks and thereby prepare the ground for bargains to be found by individual value investors. Ease of divorce is no sound basis for a relationship!