Investing secrets -Part3

Secret #6: Identifying right set of stocks

The first step to master is to be able to recognize a great stock. As we have seen, they are not glitter stocks that have appeared on the front cover of an investment magazine or recommended by a popular share market commentator. Nor are they stocks that have a trader price pattern of breakouts, double bottoms, or candle-stick trend reversals.

The second is to know what to do when a great stock comes along.Buffett has said when everything meets your criteria of it being a great business at a fair price, then buy a “meaningful amount of the stock.” Of course, this means that you can only hold a small number of companies in your portfolio. The extreme exponent of only holding a small number of stocks was Phil Fisher. For Fisher, anything over six was too many.

The more stocks you hold, the more likely your returns will be average and the more time you will have to spend keeping track of the stocks in your portfolio. You also add considerable risk because you can’t study them properly.

The third step concerns knowledge and confidence. You need the knowledge to know approximately how often a great stock comes along. You won’t make the investors Hall of Fame if your criteria are set so high that you only get to swing every other decade. On the other hand, if they are set too low then, well, they are unlikely to give you the outcome that you desire.

Secret #7: Calculate how much money you will make, not whether the stock is undervalued or overvalued according to some academic model.

AS AN INVESTOR what is the right question to ask? Most ask whether the stock is undervalued or overvalued. The problem with this is that there is no way of properly determining whether a stock is, in fact, undervalued or overvalued.

There are various academic models for calculating what is called the intrinsic value of a stock. From my extensive experience of all these models, referred to as discount cash flow models, are fatally flawed. There are four areas that bring them down. They are theoretical, contradictory, unstable and untestable.

These problems are a rather technical to explain fully so I will only give the general ideas behind them. Just because some theoretical formula labels a stock as undervalued does not mean that you are going to make money from it. For example, perhaps the price will stay at that level. The models are contradictory since different values are obtained depending on which of the many variations of the models that you use.

They are unstable since insignificantly small changes in the input variables lead to changes of 100 percent or more in the intrinsic value. This means that in instead of the models being objective, they can lead to almost any output that is desired. And finally the models are impractical because they are untestable. Some of the input variables require verification over an infinite number of years. For example, forecasts of growth rates have to be made over not just five or ten years, but extending out forever.

This is precisely the criteria that Warren Buffett uses before making an investment. In the annual report of Berkshire Hathaway a few years ago he wrote, “Unless we see a very high probability of at least 10% pre-tax returns, we will sit on the sidelines.”

In other words, Buffett is focusing on expected return, not whether the company is undervalued or overvalued.

Of course, Buffett achieves a much higher return that this. The point is that he aims at a minimum level of 10 percent—his bottom line. By locking this in but leaving open the possibility for higher returns, he achieves his remarkable results.

Secret #8: Remove the weeds and water the flowers — not the other way around

FOR MANY IT is worse than having a tooth pulled to sell a stock for a price lower than what they paid for it. If you buy a stock for 20 Rs and it drops to 10 Rs, so long as you don’t sell, then it can be referred to as an unrealized loss. In this case you can say to your spouse, “Don’t worry, dear. It’s going to come back.”

Similarly, many can’t wait to sell as soon as they can see daylight between the purchase price and the current price. If the price has gone up be a few percentages, they want to sell and “lock in the profit”.

Peter Lynch and later Warren Buffett referred to this as watering the weeds and pulling up the flowers. They are examples of what I call investor diseases. The disease of holding on to your losers I call get-evenitis. The disease of selling winners I call consolidatus profitus.

Just how wide-spread these diseases are follows from a large-scale study carried out by Terrance Odean of the University of California in Davis. His study also showed just how expensive they are, being paid for in investors’ profits.

Reporting in the Journal of Finance, 1998, he found that people tended to trade out of winners into stocks that performed less well. In the opposite direction, the study showed that the losers in their portfolio tended to continue to underperform. It was really the case that once a loser, always a loser.

Overall he found that people would have been better to sell their losers and keep their winners. Instead, they did the opposite, namely keep their losers and sell their winners.

Suppose two simple changes were made: the investors sold their losers and held on to their winners. On average, the study showed that their average annual performance would have gone up by almost five percent per year.

The difference between the two strategies is even more marked when taxes are taken into account. When you claim a loss you are getting a tax rebate and so you want this as early as possible. In contrast, with a profit you are paying tax so you want to delay this as long as possible. But, as we just learned, the average investor tends to take profits early and losses late ending up on the wrong side of the taxman.

This gives us confirmation of secret number eight: Remove the weeds and water the flowers — not the other way around

Of course, this is an oversimplification. There are times when it is better to keep a stock when the price has gone down. In fact, it may well make sense to buy more. At other times, it is better to sell a stock after it has gone up. Each case has to be treated on its own merits.

This leads to the question. Just when should you sell? A large survey carried out by the Australian Stock Exchange showed that investors found it much harder to know when to sell than when to buy.

Similar results were found in a survey of nearly 300 investors that I carried out. Almost 50 percent said that they either regularly worry or constantly worry about when to sell their stocks.

The general rule which is full of common sense is: Sell only when you can be very confident that you can do significantly better with your money in another stock. The problem is to be able to determine when this is the case.

Secret #9: Become a conscious investor

THE FAMOUS GRAPHIC artist M.C. Escher said that “most of the time we are meekly sleepwalking on a treadmill.” In other words we are acting in an unconscious way and making little progress. This certainly applies to investing. Most of the time decisions are made based on either hope or wishful thinking or on abstract academic theories.

Fortunately investing is an area that responds well to becoming more conscious of what we are doing and why. “Risk comes from not knowing what you are doing,” Buffett said.

The whole direction of Conscious Investor is to place your investing, and hence your financial future, on a firm basis of sensible and knowledgeable investing.

Yet there is another part of being a conscious investor and this is to invest in companies with products and services that you support and believe in. When you become conscious of why you want to invest in a particular company, then risk can be substantially reduced. Investing this way helps to eliminate many of the unknowns whether psychological, emotional or material.

As those who have been to an annual meeting of Berkshire Hathaway will know, Buffett gets great pleasure from using and talking about the products and services of the companies that he invests in or owns.

When you do this investing becomes easier and more fun. You don’t have the worry of having your money tied up with enterprises that you know little about. Also you will become a more astute investor since you are picking up signals about the economics of companies long before they show up in its financial statements.