We had the pleasure to be interviewed by Marc Lichtenfeld, the Chief Income Strategist at the Oxford Club. We talked about short selling strategies (Hint most investors should just avoid it) and about contrarian thinking.
“The stock market is filled with individuals who know the price of everything, but the value of nothing.” – Phillip Fisher
“Price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to…the operating results of his companies.”
—Ben Graham, The Intelligent Investor,
At Investing 501, Gregg and I try to help others improve their investment process by sharing our experiences on Seeking Alpha. One of our more popular articles was entitled, The Illusion of Control, which discussed how investors could improve their investment process by focusing on understanding businesses and how to value them and by not constantly trying to find that “new” piece of information that would bring more clarity to an investment idea. The stark reality is that we have significantly less control over our investment outcomes than we want to believe. We also posted an article on our blog entitled, “What are you hoping to gain by checking that stock price right now?” We consider the act of frequently checking stock quotes and looking at price charts to be part of the pursuit of trying to find “new” information and doing so can be detrimental to the performance of a long-term investor. In this article I will expand on the previous articles.
Next time you feel compelled to look up a stock quote, write down why you want to know what the stock is doing. After you know the quote, write down what you think you gained by doing so. How does that revelation help you in your long-term investment thesis on the company? If you truly believe that you are going to hold a stock for a few years, how does knowing what the stock is doing today add value to that thesis? There might even be some proximate news item (earnings perhaps) that is apparently driving the change in the stock price. If you are buying stocks with low valuations, the company is usually struggling from an operational standpoint. Turnaround results are not linear. The chances you bought the stock right before turnaround happens and therefore all stock price reactions to “new news” is positive is very low. My guess is there will be more negative stock price reactions to “new news” initially. Stop looking for validation of your long-term investment premise in the daily, mostly random, movements in stock prices.
The hardest thing about investing is isolating the elusive, always-different, information from the noise.
We love reading commentaries from a wide variety of investment firms. We read them to find potential new ideas or just to learn something new about analysis or investing. We thought this passage from the Frank Fund’s Q2 2013 commentary was spot on. The entire commentary is worth a few minutes of your time.
“With every investment case there are mountains of potential information available. To paraphrase Kathryn Staley from The Art of Short Selling, where creativity and experience come into play are boiling down the mass of numbers to “the most important thing.” Every buy or sell decision, long or short, should come down to a “most important” set of data, and the hardest thing about investing is isolating this elusive, always-different, information from the noise. As with Mr. Sabella’s problem of the day, it has nothing to do with the textbook, so you must draw on experience and creativity.”
“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” – Paul Samuelson
I will be the first to admit that over my 30 years in the investment field, I have wasted a significant amount of time checking stock quotes. I am also convinced that my investment returns would have been higher if I had used that time reading SEC filings and annual reports or listening to presenations or talking to other investors about ideas. Frankly, unless an investor is looking to buy or sell a stock right then or use it to calculate an enterprise value while doing research, there is little need to look up the current stock price of a company. If you are really intending on holding an investment for years, does it really matter that the stock is up or down 1% or even 5% on any given day?
Many investors think that there is a certain amount of informational content in the daily random price movements in stock. They tend to worry about what “they” know and “why” their trading is moving a particular stock price. It is my experience that rarely do “they” really “know” more than anyone else and if they are acting on information you do not know, it is almost always very short-term in nature (whisper number on earnings) or illegal (merger news) and rarely is it something fundamentally significant in the long-term. I would argue that almost every negative “surprise” that drives a stock down is actually listed as a risk in the risk section of the 10K. Good analysts and investors attempt to weigh those risks against the financial strength of the company and current and potential future valuation under “normalized” operations before they even invest. Therefore, much of the “new news” investors are reacting to should have been incorporated in the long-term investor’s analysis (both macro and company specific, good or bad).
We have pointed out numerous times about how most successful investors think like owners of businesses rather than owners of stocks. Business owners understand that wealth is created by the accumulation of cash flows over a long period of time. How much of a distraction would it be for a business owner for someone to call him up several times a day and offer to buy his business or sell a similar one at a price that was driven in by the price quote of a public “peer”? The business owner would find the process extremely distracting and an unproductive use of his time. Yet, isn’t that what investors are doing when they check the price of their stocks multiple times a day, or even just once a week?
Next time you feel compelled to look up a quote on a stock you own, ask yourself, “why” you are doing so?
- How much does it matter to your investment thesis how others are reacting to news of the day in general or company specific news? Most successful investor letters we read often speak about a position that was acquired after a large drop in the share price due to bad earnings or other announcements. They are being proactive based on their own analysis and not reactive to “new news” which they have considered in that analysis.
- If the stock is up X percent in a day, do you feel some sort of satisfaction or vindication? If the stock is down Y percent, does it make you feel uncomfortable or anxious? Does it matter that there is a news story that supposedly explains the proximate cause of that reaction?
- Many times when a stock price has changed more than 1% or so during the trading day, there is usually a news story associated with it that is attempting to explain the proximate cause of the change. How often do you find the explanation additive to your investment thesis?
In a previous post, I talked about using the right side of your brain to improve your investment process. The post also talked about Charlie Munger’s idea of “invert, always invert” when analyzing a company. I am going to suggest another way investors can “invert” to help their investment process. Oscar Wilde has been quoted as saying, “A cynic knows the price of everything and the value of nothing”. I think many investors fall into the same trap. Ask an investor or an analyst the price of a stock, they might be able to tell you off the top of their head what it is. But ask them what market cap that represents or what enterprise value to EBITDA ratio or free cash flow yield and you will most likely get a puzzled look. If you really do have to look at stock prices frequently, I would suggest setting up your quote page in a totally different way than the traditional, Open, High, Low Close format.
Instead of setting up your stock quote page to show stock quotes, set it up using valuation metrics. Pick a couple of metrics that you use in your investment process. A few metrics that we find useful are price to book value, EV/EBITDA, free cash flow yield, dividend yield and EV/revenue. I believe you will find that your emotional reaction to big changes in stock prices will start to change. Let’s use a very simple example of a stock trading at $10 a share and at that price the stock is also trading at 10X EV/EBITDA. If the stock were to drop 10%, on a typical quote set up the stock would show $9 -$1.00 (-10%). However, if we set up the quote page so that the number we see is the EV/EBITDA and set up the color code as lower is better, we would see that the stock is now trading for 9X EV/EBTIDA and the 1X decline is GREEN or positive. Investors have been so conditioned by looking at stock prices that green is good and red is bad, we can use this set up to trick our mind into understanding that lower stock prices (generally speaking) are GOOD for long-term investment returns. It has been said that there are no bad assets, just bad prices. Assuming no significant permanent impairment to long-term cash flows, as the valuation of an asset declines, its expected return increases.
Another thing you will start to see that a 1% or 2% or even 5% change in the price of a stock has little impact on the valuation of the company. Using the example above, a 2% change in the price of the stock would mean that the EV/EBITDA changed from 10X to 9.8X. I would hardly call that material, even though seeing a 2% decline in a stock in a day may feel bad. Need another reason to try this? Studies have shown that equity valuations change 19 times the underlying fundamentals. So even rather large relative changes in stock prices, which feel like they represent an adequate re-pricing of “new news” usually overstate the true change in the long-term fundamental valuation of the company. Yes this is overly simplistic. Stocks do not decline 10% in value in a day for “no reason”. Earnings estimates are most likely to be lower after such a decline, but the company’s book value probably won’t change much and neither will the long-term earnings power. This is not so say that our original thesis is not wrong and cannot change based on current events. But as a business owner, we are spending our time thinking about the long-term competitive strengths and weaknesses of the company and should understand when the near-term results may in fact be signaling a change in our thesis.
If you set up your quote screen in the way I suggest, I think you will find yourself looking at it less often because valuations don’t change as much day to day, reducing the “entertainment value” of looking up stock price movements. I think you will find your investment returns will improve over time and you will spend more of your investment process time reading annual reports, SEC filings, transcripts of conference calls and presentations and searching the internet for relevant information on the company or its products.
The genesis of this post is couple of documents that I rediscovered on the ValueWalk Scribd page. The first is a speech given in 1981 by Dean Williams of Batterymarch Financial Management entitled, “Trying Too Hard”. The second is a research publication written by James Montier called, “Seven Sins of Fund Management”. Ironically, one of the main points made in both pieces is that investors (me included) spend too much time exposing themselves to all the informational noise that is distributed over the internet in the hope of boosting confidence enough to be comfortable with our investment decisions. As my co-founder Gregg constantly points out, over the long-run you will probably do better building a portfolio of companies that makes you uncomfortable than building one that makes you comfortable. In this article I am going to discuss why your investment process should be focused simply on understanding and valuing businesses, and being better at it than other investors. Trying to increase your confidence by gathering information that is supposedly unknown to most others really only makes you more comfortable with your investment decisions, not better at them, and is generally an unproductive use of your limited time.
“There are no answers in this business. There’s just a hell of a lot of questions.”-George Russell Jr. of Frank Russell Co.
Relative to the last ten to fifteen years, there has been a significant increase in the amount of investment-oriented information available to investors. In trying to provide investors with information that “is not in the current stock price” and therefore giving them an “edge”, many Wall Street, and independent investment research providers have begun focusing on such areas as “forensic” accounting, “channel checking”, public policy analysis, “lie detection” on conference calls, data mining and “expert” networking. Investors can find a diversity of opinion on a company because professionals and non-professionals alike publish and share their investment ideas on sites such as Seeking Alpha, Motley Fool, GuruFocus, Value Investors Club and SumZero. There are numerous investor conferences where attendees can hear ideas from “gurus”, portfolio managers, activist investors and contest winners. There are bloggers who aggregate news stories and analysis. Investors can set up RSS feeds and use websites like Reddit to keep abreast of all the investment news they deem important. But do we really need to be doing all of this? How much information is enough and how much is too much? Let’s just say that the signal-to-noise ratio for investors has degraded substantially over the yearsIn spite of the large increase in investment information relative to the past, there is little evidence that active managers in aggregate have improved their performance relative to passive strategies. In addition, assets in passive investing strategies continue to increase as a percentage of total invested assets. Instead of lengthening investing horizons because investors have more information to make supposedly better long-term decisions, the obsession with trying to utilize all of this information has actually shortened them. Average holding periods of stock in mutual funds is under 11 months and the SPY turns over its assets once a week (investment periods which are too short for fundamental oriented investment returns to manifest themselves). It appears as though trading a stock on “the new news” has replaced investing in a real business for the long-term as an acceptable investment strategy.
The following article is the first part of a series designed to help investors develop their own investment process and increase the efficiency of dealing with the daily deluge of investment ideas that are now available to investors, thanks to the internet.
A long time ago when I was trying to learn how to draw and paint (note: unless childlike stick figures become immensely popular I failed, which is why I became a photographer), I read a book called Drawing on the Right Side of the Brain by Betty Edwards. The idea of the book was to help a person tap on the strengths of the right side of the brain and “deepen your artistic perception” when engaging in creative endeavors. Athletes and musicians often talk about “being in the zone” and from personal experience as an investment analyst, a drummer, and a professional sports photographer, I can tell you that you can put your brain in either a “right brain” or “left brain” thinking mode. One of the first exercises in Edward’s book is to look at a picture and draw it. More than likely it will look “ok” but the perspective and other things may not look just right. The author then tells the reader to turn the picture upside down and draw it again. You would be amazed at how much closer to the original the second drawing looks than the first attempt. Why is that? Edwards explains that since the brain doesn’t recognize the upside down drawing as an object, the brain switches to the right side and allows the artist to “see it” more in the abstract and not a preconceived recognizable image, which makes it easier to “draw” the lines more accurately. Since successful analysts incorporate the ability to think in non-linear, non-analytic ways; being able to tap into those aspects of the right side of the brain is very important. This idea can be thought of as “inversion.”
This is all you need to know about Wall Street analysts and their ratings..
Bespoke Investment Group has a great chart showing how few analysts followed Apple in 2000-2004. But as the stock price rose, so did the number of analysts following the company and the number of buy ratings.. Now that the stock has been a poor performer, analysts are changing their tune. Classic trend following and only concern for the somewhat visible near term.