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On Stock-picking and Stock-pickers

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We are not single stock pickers, we generally do not use single stocks in our client portfolios and we base virtually all comments on a company’s SEC filings, information on Yahoo! Finance, information available on the company’s website and articles in major publications. We do not offer buy or sell recommendations. We are almost always commenting on a company’s business, not their market valuation. Stock prices and company fundamentals sometimes go in tandem, sometimes not. Stock price often already reflects expectations of changes in fundamentals and even those disconnected from fundamentals can stay that way for a long, long time.

So why do we bother analyzing companies?

We will sometimes offer commentary on an individual company because understanding the individual players within the economy offers insights into broader trends. Most of our clients have equity based compensation and sometimes we think that what we learn from studying their employer is worth sharing. It also is fun, if you like making financial diagnoses from incomplete financial information like a company’s 10-Q filings. Kinda like House, but a company’s health instead of a real person’s.

Here is an old essay on stock-picking:

On stock-picking

Over the years, I’ve become more and more convinced that stock-picking is an exciting but expensive hobby– both for “amateurs” and so-called professionals. This is backed by more or less all academic research and my personal experience. The best book designed for general consumption that explains why is A Random Walk Down Wall Street. If you have the urge to invest in stocks but haven’t read it and you spot it in a used book store or at a library book sale, definitely pick it up. There are about a zillion editions, any one will do.

I personally subscribe to a camp which academics call the “weak-form of market efficiency”. While I definitely believe stock market, and individual stock, valuations are subject to whims and fancies of investors, I don’t believe they vary in a way that is consistent enough to make money over time using a “system”. There was a whole group of guys I used to work with who were always trying to fine-tune their model but every time they thought they’d figured out how to print money, real life got in the way. And while I don’t believe most stocks at anyone time represent their “true” worth, the mechanisms to correct valuation are crude. If stocks get way too cheap, there are LBO firms to scavenge around and when valuations get too high the venture capitalists get to work, just like they did in the late 1990s. But in between, it’s more or less anyone’s guess as to if and when sentiment will change. And for individual stocks, idiosyncratic risk (eg brilliant CEO gets brain cancer) is high enough to make investing in any one surefire winner extremely risky.

There is one strategy, however, that has historically done well over time — but when I say time, I mean decades. Eugene Fama and Kenneth French were the researchers who first made “value investing” famous. If you look at almost all the famous investors through time, more or less they all fall into the value or contrarian camp (Buffett, Graham, Templeton, Lynch, Neff, Price).

Value investing means buying companies that look cheap, really cheap. There are any number of plausible reasons why value investing makes sense.

Fama and French hypothesize that a company selling for a low valuation relative to its assets is probably a distressed company and that investors demand a really big discount to invest in a company with known problems.

Burton Malkiel (author of a Random Walk) would argue that “growth” companies sell at a price which incorporates the best case so they have little room for appreciation and a lot of room to fall if they lose their luster with investors and value stocks, conversely, can’t fall much further and if redeemed have room to go up. Structurally, Wall Street moves mostly as a herd and prefers winners which gives support to both these ideas.

Value investing is hard for Wall Street to do though. As its alternate name, contrarian, suggests, it means doing something that most other people are not. Your stocks go up when everyone else’s go down but can go down when everyone else’s portfolio is skyrocketing. For nascent portfolio managers benchmarked to the S&P 500, this out-of-stepness can end careers. And buying and loving the dogs can turn even the toughest investor’s stomach.

So what to do? Easy. Buy a passively managed portfolio of value stocks as part of diversified portfolio with more normal looking things. Passive? Yes, passive. Passive, in my mind, means any strategy that is dictated by quantitative inputs.

Here are the arguments against active mutual fund management:

1) Over time, more or less no one outperforms the market. Even most of the success of the “famous investors” can almost all be explained by a value tilt. And then there are the less famous managers…

2) Active managers feel compelled to trade to earn their outrageous fees. This costs investors in so many ways I can’t even talk about it without starting to choke.

3) Their outrageous fees.

So why can’t most mutual fund managers outperform? I could write and write and write on this topic, but I have children to raise and financial plans to write. I think it is partly a function of the mutual fund structure itself, partly the way fund managers are rewarded, partly the incestuous nature of Wall Street and partly that it is more or less impossible to outperform the market and have a truly diversified portfolio.

And even if someone could outperform the market — how would you know? Random chance dictates that certain managers will always do better than the average. By the time you figure out some guy or gal is for real, they decide to retire or they have a baby or the market changes so whatever advantage they had fades.

What do you do though if you are hopelessly addicted to stock-picking?

1) Put the vast majority of your money into that ideal passive diversified portfolio. Then, compare your performance(including taxes paid) to decide whether you’d rather take up golf or hot air ballooning and pick stocks in a fantasy league.

2) Have an investment thesis. Understand what you are buying and why so if things change you can reevaluate.

3) Buy value.

4) Sell when it stops being value or your assumptions in your investment thesis turn out to be wrong (hard to do if you didn’t note your assumptions to begin with).

Easy, right?

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