The purpose of these blogs is to give private investors basic information about shares selection and other related topics. Contrary to the impression that investment books of the "how to make a million" variety and those written in "Noddy and Big Ears" style give, there is no guaranteed or easy way to make money by investing in shares.
I introduce the topic of each blog with my thoughts and then give numerous quotes on the topic from investors who have the best long term, public track records, and also from highly regarded academics regarding the topic.
In selecting a share to buy, the investor should perform three key evaluations: the economics of the business, the quality of the management and the valuation. All of these are very difficult to do but, the more research you do, the more you increase your probability of not losing money on bad investments. I have described some of the considerations when doing each of these evaluations in the next three blogs (click on the links in the "blog archives" in November 2007 on the right).
I have also blogged on various topics that would interest private investors. These include things like charting, index trackers, contrarian investing, etc (click on the links in the "blog archives" in November 2007 on the right).
Finally, most private investors who are investing for the long term can avoid the big risks, of trying to outperform the market, by investing their savings in index trackers (see http://mythoughts-mohan.blogspot.com/2007/11/index-trackers.html) and forgetting about them till they need the money when they retire. The only caveat is not to invest when the market is in bubble mode (see http://mythoughts-mohan.blogspot.com/2007/11/bubbles.html). They would also thereby avoid spending the huge amounts of time required to investigate individual shares and can use the time saved more productively to build their careers and enjoy whatever else they enjoy.
Introduction
The business
The economics of the business is one of three key evaluations that an investor has to make. Of the three key evaluations, this is easier (though still very difficult) than the other two key evaluations of management and valuation.
Michael Porter’s book “Competitive Strategy” describes five forces that determine industry profitability. This provides a useful framework to evaluate the business.
1 Ease with which new entrants can compete: The higher the entry barriers, the better. Entry barriers include large capital costs to set up, brand loyalty for existing businesses, difficulty of setting up new distribution networks coupled with difficulty of accessing existing distribution networks, high learning curve for new products, difficulty of obtaining inputs, threat of retaliation by strong existing businesses.
2 Bargaining power of suppliers: The best case is where the business can choose to buy its materials and services from a large number of suppliers who are competing strongly among themselves.
3 Availability of substitutes: The customers should preferably not have substitutes to choose from. If substitutes are available, then the questions to be addressed are the relative price of the substitutes and the ease with which the customer can switch to using substitutes. Concorde was the most technologically superior passenger plane of its time. But competion from technologically inferior planes, which passengers preferred for their lower price, made Concorde commercially unviable.
4 Bargaining power of buyers: Obviously, the lower the bargaining power of the buyers, the better. The worst case is where the business is dependent on a single buyer as was the case with the British suppliers to Marks and Spencer when M&S abandoned its policy of buying British to seeking suppliers offering the best deal, wherever they may be.
5 Rivalry amongst existing businesses: Some businesses have such intense rivalry that, while this is great for the customers, none of the businesses make satisfactory profits. This commonly happens in commodity type businesses where the customer does not care who the supplier is as all the offerings satisfy his needs.
It is also very important to identify and evaluate the risks inherent in the business as your capacity for and attitude to risk may be incompatible with the inherent risks of some businesses. Some examples:
1 Technology businesses are vulnerable to their products being made obsolete by new technologies and then the sale of the erstwhile best selling, but now obsolete, products drop off sharply. This is specially risky for one product companies rather than those that hold a portfolio of different products. Once great photography companies like Kodak and Polaroid lost their advantage when digital cameras made their products obsolete.
2 Cyclical business like shipping, construction and property which have years of good profits followed by years of losses. At the end of each cycle is there value creation or destruction?
3 Businesses prone to disasters that can wipe out many years of profits, e.g. banks, pharmaceuticals, etc. Warren Buffett: The banking business is no favorite of ours. When assets are twenty times equity ... mistakes that involve only a small portion of assets can destroy a major portion of equity.
Below I give quotes from some of the most successful investors regarding selection of businesses suitable for consideration.
Warren Buffet
1 It will rarely, if ever, pay you to buy a bad business at any price.
2 Good jockeys will do well on good horses, but not on broken down nags. When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.
3 We favour businesses and industries unlikely to experience major change. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek. As investors, our reaction to a fermenting industry is much like our attitude towards space exploration: We applaud the endeavor but prefer to skip the ride.
4 A horse that can count to ten is a remarkable horse – not a remarkable mathematician. Likewise a textile company that allocates capital brilliantly within its industry is a remarkable textile company – but not a remarkable business.
6 It is no sin to miss a great opportunity outside one’s area of competence.
7 Time is the friend of the wonderful business, the enemy of the mediocre. It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
8 In a difficult business, no sooner is one problem solved than another surfaces.
9 I have not learned how to solve difficult business problems. What we have learned is to avoid them. In both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult. We’ve done better by avoiding dragons than by slaying them.
10 A business that must deal with fast-moving technology is not going to lend itself to reliable evaluation of its long term economics.
11 Obviously many companies in high-tech businesses or embryonic industries will grow much faster in percentage terms... But I would rather be certain of a good result than hopeful of a great one.
12 Your goal as an investor should simply be to purchase, at a rational price, a part investment in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.
13 ... a great investment opportunity occurs when a marvellous business encounters a one-time huge, but solvable, problem as was the case many years back at both American Express and GEICO. Overall, however, we've done better by avoiding dragons than by slaying them.
John Ballen
1 There are some very capital-intensive industries where it is very difficult to have sustainable returns over the longer term.
John Neff
1 I advised fund directors to restrain stock selections in the industrial products segment to predictable companies in predictable industry climates.
Van Schrieber
1 Find the best industry, the one which is in the forefront of innovation; then find the best participants in that industry and buy those stocks.
Scott Johnston
1 You want to focus on the strongest industry sectors and the strongest stocks, because the better, stronger companies should decline less in a bear market and come out of the starting blocks faster during the rebound in a bull market.
2 I want companies in industries that are doing well in the market pricewise. It is it's awfully difficult for any company to be doing well in an industry that is doing poorly. If you have a sector that's flat on its back, it might be the greatest company with the greatest story ever, but when the institutional salesmen are out there calling around trying to get your interest, the answer is likely to be, hey, forget it. I don't want to own semiconductors; it's a dead group
Laura Sloate
1 We don’t invest in technology stocks. The creators of technology have their own network and you really have to understand it.
Burton Malkiel
1 Investments in transforming technologies have often proved unrewarding for investors. In the 1850s, the railroad was widely expected to greatly increase the efficiency of communications and commerce. It certainly did so, but it did not justify the prices of railroad stocks, which increased to enormous speculative heights before collapsing in August 1857. Electricity in the early twentieth century had profound effects on the layout and design of factories and led to a large increase in the productive efficiency of the economy. But throughout the first two decades of the century, electric utilities were poor investments. Similiarly, airlines and television manufacturers transformed our country, but most of the early investors lost their shirts. The key to investing is not how much industry will affect society or even how much it will grow, but rather its ability to make and sustain profits.
Peter Lynch
1 When somebody says “Any idiot could run this joint”, that’s a plus as far as I’m concerned, because sooner or later any idiot is probably going to be running it.”
Benjamin Graham
1 Obvious prospects for physical growth in a business do not translate into obvious profits for investors.
2 The experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries.
Management
The quality of management is one of three key evaluations that an investor has to make. This is extremely difficult to do. And even if you do find a company which you think has outstanding management, ensure that it also satisfies the other two evaluations of economics of the business and valuation of the shares.
The difficulty of judging the quality of management is illustrated by the numerous instances in which chief executives who were once lauded as brilliant have later been proved to be quite ordinary or worse and that their “success” was due to taking big risks (e.g. Northern Rock) or even outright fraud (e.g. Enron).
Stephen Lofthouse discusses the problem of trying to select bargains based on insights into the quality of management:
“There are three reasons why one might suspect that high quality management does not lead to abnormal returns. First, good management should already be reflected in earnings, sales, etc. Second, even if good management is a separate factor (because today’s earnings represent yesterday’s management whereas today’s management will generate tomorrow’s earnings) why is this not already reflected in a share’s price? Third, what is good management, and who would recognise it?”
He describes a study by Michelle Clayman of the companies judged as excellent in Peters and Waterman’s “In search of excellence”. The list of excellent companies was compiled in 1981. Of the original 36 publicly traded, the study covered 29 companies as only these had complete data. Over the period 1981-85, 11 of the 29 companies outperformed the S&P500 and 18 underperformed. She then looked at 39 companies that were regarded as dogs and found that 25 outperformed the S&P500 and 14 underperformed. You will find more details of the study at http://www.professionalwealth.com.au/admin/file/content3/c2/PW%20In%20Search%20of%20Unexcellence.pdf
Occasionally you may get an opportunity to invest in a company that has been brought to its knees by poor management, when that management is replaced by high quality management. For example, this was the case at Asda at the end of 1991 when Archie Norman was brought in to sort it out. Investors who invested in Asda then would have made a lot of money through his success in turning around the ailing supermarket culminating in its sale to Wal-Mart in 1999. You can read about this at
http://www.asda-corporate.com/about-asda/history.asp
Unless such a change in management is imminent, it is best to avoid companies with bad management. It is easier to identify bad management. Some of the symptoms are:
1 Where there are doubts about its integrity. Warren Buffett: I learned to go into business only with people whom I like, trust and admire.
2 Ostentatious lifestyles, e.g Kozlowski of Tyco
3 More than one member of the family on the board, due to nepotism.
4 Who habitually blame political and economic conditions and other outside forces for poor results.
5 Who build plush offices. Northcote Parkinson observed that fountains sprouting in the foyer are the first sign of decline. Nigel Lawson advised avoiding companies that have just moved into a lush new head office. Peter Lynch: Rich earnings and a cheap headquarters is a great combination…. Other bad signs include fine antique furniture, trompe l’oeil drapes, and polished-walnut walls.
6 Where management remuneration is excessive in relation to peers in the competing companies or the incentives are too generous and easy to achieve. Lynch: I thought to myself: If I make money in Televideo, this guy is going to be worth $200 million. That didn’t seem realistic either. I declined to invest and that stock went from $40 in 1983 to $1 in 1987. Buffet: Most managers employ compensation systems that are long on carrots but short on sticks (and that almost invariably treat equity capital as if it were cost-free).
Valuation
The three key evaluations that an investor should make are those of the economics of the business, the quality of the management and the valuation of the shares. There are lots of good businesses with good management but this is generally reflected in the price; it is rare that you will find these at a bargain price.
The theoretical basis of valuation is simple – it is the discounted present value of all future cash flows (dividends, payments for rights, returns of capital, etc) at the time of valuation. This is commonly known as the dividend discount model. (The future share price is irrelevant because when a shareholder sells the share, the price should be the discounted value of future cash flows at the time of sale.) But the application of this basis is impractical because future cash flows for shares, unlike gilts, cannot be forecast with sufficient accuracy and because even small changes to the discount rate, which is necessarily subjective and not a constant, result in huge differences in the resulting value.
The dividend growth model is derived mathematically from the dividend discount model and is therefore theoretically sound. Basically it says that the price should be the expected dividend divided by the difference between the expected return and growth rates. Or, rearranging the terms of the equation, the return will equal the present dividend yield + growth rate of dividends. This is a useful concept for making a quick calculation of the expected return if investing in a company that has a yield and where the dividends are expected to grow at a constant rate forever. Dividends do not, in fact, grow at a constant rate forever but it is nevertheless a useful rough and quick method of estimating expected return for some companies.
Various methods of valuation are used such as abnormal earnings valuation (including economic value added), price / cash flow, return on equity / capital employed, etc. All these methods suffer from the fundamental limitation of the quality of the data from which they are calculated.
The price/earnings ratio (PER) is the most widely used method for determining whether shares are “correctly” valued in relation to one another. But the PER does not in itself indicate whether the share is a bargain. The PER depends on the market’s perception of the risk and future growth in earnings. A company with a low PER indicates that the market perceives it as higher risk or lower growth or both as compared to a company with a higher PER. The PER of a listed company’s share is the result of the collective perception of the market as to how risky the company is and what it’s earnings growth prospects are in relation to that of other companies. Investors use the PER to compare their own judgements of the risk and growth of a company against the market’s collective perception of the risk and growth as reflected in the current PER. If the investor feels that his perception is superior to that of the market, he can make the decision to buy or sell accordingly.
In practice, all valuation is relative – not only in respect of shares relative to other shares but also as between different asset classes such as shares relative to gilts. So for example, the PER of GlaxoSmithKline will be relative to that of Astra Zeneca taking into account the risks and growth prospects of each. Or the expected return from shares may be compared to that from gilts – the return from gilts can be predicted with certainty if held to maturity so that there is no risk of deviation from the expected return as in the case of shares but then the earnings/dividends from shares are expected to grow while the interest from gilts will remain constant and the relative valuations will reflect these considerations. The obvious limitation of using relative valuations is that all the valuations may be too high or too low. Thus, in a bubble, relative valuations may be reasonable but, when the bubble bursts, all the shares will be marked down. So the investor also has to make a judgement as to whether the market as a whole is under or over valued.
A totally different approach to valuation is that per Keynes. Richard Barker describes this in his excellent book "Determining Value" from which I quote selectively below:
Perhaps the best-known and most insightful analysis of the speculative determination of stock market prices can be found in Keynes' General Theory (Keynes, 1936, Chapter 12). Keynes identifies two features of the stock market that lead to speculative behaviour. The first of these is the uncertainty of the future. "Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible..."
... Keynes identifies liquidity as the second feature of stock markets that induces speculation. "In the absence of security markets, there is no object in frequently attempting to revalue an investment to which we are committed. But the Stock Exchange revalues many investments every day and the revaluations give a frequent opportunity to the individual ... to revise his commitments. It is as though a farmer, having tapped his barometer after breakfast, could decide to move his capital from the farming business ... and reconsider whether he should return to it later in the week."
In Keynes' analysis, the two factors uncertainty and liquidity combine to generate speculative bubbles. The importance of the first factor, uncertainty, lies in its influence on investors' perceptions of current stock market valuations. Investors develop what Keynes calls 'conventions', meaning commonly accepted beliefs about the uncertain future... In effect of course, these conventions are myths, because we cannot have certain knowledge about the future.
"... [Professional investors] are, in fact, largely concerned, not with making superior long term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead [of others] ... For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence."
Novice investors are often under the delusion that there is a method of calculating the precise value for a share and spend time trying to discover this method. They are no more likely to discover it than the alchemists who tried to discover how to turn base metal into gold. In practise, it is sufficient to form a judgement as to whether a share is significantly under or over valued.
Some quotes from big names in investment about the importance of valuation:
Benjamin Graham
- If forced to distil the secret of sound investment into three words, they would be: margin of safety.
- The really dreadful losses ... were realized in those common-stock issues where the buyer forgot to ask "How much?"
- ... stocks with good records and apparently good prospects sell at correspondingly high prices. The investor may be right in his judgement of their prospects and still not fare particularly well, merely because he has paid in full (and perhaps overpaid) for the expected prosperity.
- No amount of study in this area can minimise the importance of trying to buy at a fair price; buying at any price and hoping that the future will take care of itself is a good shortcut to disappointing results.
- Mr Market gives you opportunities to buy shares above and below intrinsic value. So risk can come in because you’re buying a great franchise, a great business, run by wonderful people, but at too high a price.
- The firm foundation theory relies on some tricky forecasts of the extent and duration of future growth.
- Depending on what guesses you make, you can convince yourself to pay any price you want to for a stock.
- Over shorter periods, changes in the price-dividend or price-earnings multiple is critical in determining returns.
- Unsustainable prices may persist for years, but eventually they reverse themselves. Such reversals come with the suddenness of an earthquake; and the bigger the binge, the greater the resulting hangover.
- Never pay more for a stock than its firm foundation of value.
- Dividend increases are usually an accurate indicator of increases in future earnings.
- I have a good friend who once built a modest stake into a small fortune. Then along came a stock called Alphanumeric. I begged him to investigate first whether the huge future earnings that were already reflected in the share price could possibly be achieved given the likely size of the market. He thanked me for the advice but dismissed it by saying that stock prices weren’t based on “fundamentals” like earnings and dividends. “They are based on hopes and dreams” he said. And so my friend had to rush in before greater fools would tread. And rush in he did, buying at $80, which was close to the peak of a craze in that particular stock. The stock plunged to $2, and with it my friend’s fortune. The ability to avoid such horrendous mistakes is probably the most important factor in preserving one’s capital and allowing it to grow.
Warren Buffett
- It is better to be approximately right than precisely wrong.
- You do not have to know the exact weight of a person to know that he is fat.
- Investors making purchases in an overheated market need to recognize that it may take an extended period for the value of even an outstanding company to catch up with the price they paid.
- This kind of uncertainty [where it is not possible to be certain with any degree of certainty of the outcome] frequently occurs when new businesses and rapidly changing businesses are under examination. In cases of this sort, any capital commitment must be labeled speculative.
- The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money.
- ... we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We're not smart enough to do that and we know it. Instead, we try to apply Aesops's 2,600-year-old equation to opportunities in whch we have reasonable confidence as to how many birds are in the bush and when they will emerge. Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Even so, we make many mistakes.
See also my blog on bubbles at http://mythoughts-mohan.blogspot.com/2007/11/bubbles.html
Risks of investing in shares
Everybody knows that investing in shares is risky. But most investors underestimate the risk. Before investing in shares, it is important to consider both your capacity for risk and your attitude to risk.
Your capacity for risk depends on the probability with which you will be able to accumulate capital again if you lose it. For example, if you have a long career ahead of you it would not matter so much if you lose some of your capital. But it would be disastrous if you are towards the end of your career and need the capital for your retirement.
Your attitude to risk is very important. For example, investors who consider themselves to be long term investors often panic and sell at the wrong time when their shares fall sharply.
Only you can know your capacity for and attitude to risk. Therefore, only you can make the decision as to whether a particular investment is suitable for you bearing in mind the risk of the investment.
Few investors over-estimate the risks but many under-estimate the risks. For the latter category, I give below words of wisdom of some of the most highly rated investment professionals:
Peter Bernstein:
- Despite the mountains of historical experience and despite the elegance of the statistical tools and the law of probability that we can apply to that experience, novel and unexpected events are constantly taking investors by surprise. Surprise is what explains the persistent volatility of markets; if we knew what lay ahead, we would already have priced the certain future into market valuations. The roaring bull market of 1958 drove the dividend yield on stocks emphatically below the yield on long term bonds. Nobody even questions the relationship today. Paradigm shifts are normal.
- If you have saved a large amount for retirement and do not plan to leave a large estate for your heirs or to charity, you may require a very low return to meet your ongoing financial needs. In that case, there would be little sense in choosing a high risk/return mix, no matter how great your risk tolerance.
- Re Long Term Capital Management: Focussing narrowly on only several years of financial data, they forgot the fact that occasionally markets come completely off the rails, often in ways never before seen.
- The popular conceit of every bull market is that the public has bought into the value of long-term investing and will never sell their stocks simply because of market fluctuation. And time after time, the investing public loses heart after the inevitable punishing declines that stock markets periodically dish out, and the cycle begins anew.
- Returns are uncertain but risks can be controlled.
- Risk and return are inextricably connected. If you desire the opportunity to achieve high returns, you have to shoulder high risks. High investment returns cannot be earned without taking substantial risks. Safe investments produce low returns.
- The pattern of annual stock returns is almost totally random and unpredictable. The return in the last year, or the past five years, gives you no hint of next year’s return – it is a “random walk”. The twentieth century has seen three severe drops in stock prices, one of them catastrophic. The message to the average investor is brutally clear: expect at least one, and perhaps two, very severe bear markets during your investing career.
- A near zero real return over 20 years is not an uncommon occurrence. It happened three times in the twentieth century: from 1900 to 1920, from 1929 to 1949 and from 1964 to 1984.
- Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.
- The determining question in structuring a portfolio is the consequence of loss; this is far more important than the chance of loss. The failure to understand explicitly how much volatility risk can actually be tolerated in a given situation all too often encourages owners to dampen volatility by attempts to time the market which typically leads to mediocre long-term performance results. To the extent that the market is mostly efficient, we can expect only modest improvements in portfolio returns from active asset management.
- This is a humbling profession, with minefields all over the place capable of destroying a good performance record built on years of hard work.
- The ideal investment portfolio is divided between the purchase of really secure future income (where future appreciation or depreciation will depend on the rate of interest) and equities that one believes to be capable of a large improvement to offset the fairly numerous cases that with the best wills in the world, will go wrong.
- Markets can stay irrational longer than you can stay solvent.
- If one is lucky enough to possess a sum that is unwieldy because of large size, the important thing to do is to employ only that portion of one’s capital that one does feel he can “double”. It is better to leave the rest sterile than to risk it pointlessly.
- It is true that cash has lost purchasing power … but at a very slow rate compared to the rapid depreciation that can be suffered in a real stock market decline.
- The successful investor will keep his capital idle in times of popular over-investment and over-confidence. He will be sorely tried at times when profits and income are seemingly easy to procure.
- Financial turbulence is not rare; it is at the heart of our markets.
- Many users of MPT seem to see an implied precision in their quantitative machinations and gain a comfort there from that may be dangerous. This danger arises primarily because it diverts too much attention from the big question of whether to own stocks or bonds at all, and in what relative amounts.
- [After 1967] the Dow Jones Industrials didn’t close over 1000 to stay until 1982. Thus an investor who hitched a wagon to the Dow in January 1966 waited 16 years for a meaningful capital gain. When inflation over the span is considered, the investor suffered a 60 percent loss.
- My mission isn’t to make money in bull markets. My mission is to preserve capital.
- Reply from a “sensible fellow” who had spent 25 years trading bonds with other people’s money to the question “What would you do if you had, today, $250,000 of your own?”: “I would put in into 25 envelopes, in cash, of $10,000 each. At the beginning of each year I would take out an envelope and I would risk not living more than 25 years longer. That would give me $200 a week. But, since a man has got to be doing something and I like gambling, I would live on a hundred a week and with the other hundred I would play the horse races. That would give me a real interest in life. Most weeks I’d live at the rate of a hundred – but occasionally at the rate of a thousand.”
- All our emphasis on never losing money is that the bulk of our money is private capital. Private money is a precious, irreplaceable commodity.
- The returns derived from the past are not hard constants, like the speed of light. Historical values must be tempered with an appreciation of how investors, attempting to take advantage of the returns from the past, may alter those returns in the future.
- The thesis of this book strongly implies that stocks have been chronically undervalued throughout history. This has occurred because most investors have been deterred by the high short-term risk in the stock market and have ignored their long-term record of steady gains. One interpretation of the current (1998) bull market indicates that investors are finally bidding equities up to the level that they should be on the basis of their historical risks and returns. In that case, the current high levels of stock prices relative to fundamentals means that future returns on equities might well be lower than the historical average.
- How frequent the profit is irrelevant; it is the magnitude of the outcome that counts. (He gives examples of traders who enjoy many years of success but then suddenly become “wiped out” due to an event that is unanticipated or of very low probability.)
Charting, etc
There are a few well known shares investment managers who have, whether by luck or by skill, consistently outperformed the market indices. But none of them have done it by following charts (or so called "technical analysis"). It is sad to note the huge amounts of time wasted on trying to make money by "interpreting" charts. And sadder still to see the amounts of money wasted by those who think that they can make money using charting.
The explanation for the popularity of charting appears to be that human beings "see" patterns in random phenomenon. As one would expect, in this age of super fast computers, every "pattern" of share prices has been analysed to see whether money can be made from it and no such patterns have been found.
Some succesful investment professionals like Anthony Bolton do use charts. But even they use it only to support their fundamental analysis. By and large most successful investment professionals and academics do not consider charts to be useful in making investment decisions:
- ...guided by charts...so called "technical approaches"...over 50 years, we have not known a single person who has consistently or lastingly made money by this "following the market".
- As any chartist has learnt to his sorrow, the most random and independent events can spontaneously appear to form patterns and cycles.
- Short-run changes in stock prices cannot be predicted.
- The financial institutions have the funds to move the price so rapidly that no chartist could get into the act before the whole play is gone. If some people know that the price will go to 40 tomorrow, it will go to 40 today.
- I have never known a successful technician but I have seen the wrecks of several unsuccessful ones.
- The basic premise is that there are repeatable patterns in space and time. These technical rules have been tested exhaustively by using stock price data on both major exchanges going back as far as the beginning of the twentieth century. The results reveal that past movements in stock prices cannot be used reliably to foretell future movements.
- If you examine past stock prices in any given period, you can always find some kind of system that would have worked in a given period. If enough different criteria for selecting stocks are tried, one will eventually be found that selects the best ones of that period. What most advocates of technical analysis usually fail to do is to test their schemes with market data derived from periods other than those during which the scheme was developed.
- Any successful technical scheme must ultimately be self-defeating. If people know a stock will go up tomorrow, you can be sure it will go up today.
- All I was ever able to conclude from my studies was that chart reading is a complex way of arriving at a simple theorem, to wit: When they have gone up for a considerable time, they will continue to go up for a considerable time; and the same holds true for going down. This is simple but it does not happen to be so.
- It is the popular feeling in Wall Street that chart readers are pretty occult professors but that most of them are broke.
- For most people charts have a peculiar way of appearing simple and it is very costly to find out that they are far from it.
- In the second class, I would place self-styled accomplished chart or tape readers who are guided exclusively by what they think they see in lines on the charts. My guess is that they lose in the long run.
- Poor performance often occurred as a consequence of a technical orientation that tried to predict peaks and troughs in stock charts. It assumed that where a stock has been implies where it is going. Playing the technical or momentum game always has seemed misguided to me.
- The problem with momentum investing is that the river rushes most rapidly just before it plunges over the falls.
- Thousands of experts study overbought indicators, oversold indicators, head-and-shoulders patterns, put-call ratios … and they can’t predict markets with any useful consistency. I don’t pay much attention to that science of wiggles.
- Investment success will not be produced by arcane formulae, computer programs, or signals flashed by the price behaviour of stocks and markets. Rather an investor will succeed by coupling good business judgement with an ability to insulate his thoughts and behaviour from the super contagious emotions that swirl about the marketplace.
- Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.
Book values
Financial statements can be deceptive in many ways. One of the most deceptive is the "book value" derived from financial statements. This is particularly so because a lot of "pundits" give it credence and it is used in many ratios to "evaluate" investments and is very popular with data miners.
Market timing
Many investors feel that they can make more money by getting in and out of the market when they feel that share prices generally will go up or down. The brokers (commission), market makers (spreads) and government (stamp duty) will certainly make more money from investors who trade. Investors who try to time the markets are more likely to lose money. Even the very successful professional investors and academics do not believe that it is possible to time the markets. Here's what some of them have to say about market timing:
Benjamin Graham
1 ... a policy of entering the market when it is depressed and selling out in the advanced stages of a boom. ... the market's action in the past 20 years [ending 1971] has not lent itself operations of this sort on any mathematical basis.
Burton Malkiel
1 An investor who frequently carries a large cash position to avoid periods of market decline is very likely to be out of the market during some periods when it rallies smartly. 95% of the significant market gains over the thirty-year period from the mid-1960s through the mid-1990s came on 90 of the roughly 7,500 trading days.
2 An investor who frequently carries a large cash position to avoid periods of market decline is very likely to be out of the market during some periods where it rallies smartly. During the decade of the 1980s, the Standard & Poor's 500 Index provided a very handsome total return (including dividends and capital changes) of 17.6%. But an investor who happened to be out of the market and missed just the ten best days of the decade - out of a total of 2,528 tading days - was up only 12.6 percent. Similar statistics are descriptive of the entire period from the early 1960s through the 1990s.
3 Obviously, being ''out of the market'' during a period of sharp decline, such as October 1987, would have saved you a lot of grief and money. We all hear of those ''astute'' few who ''knew'' the market was too high in early October and sold out. But unless those timers got back into the market right after the lows were hit, they were not more successful than investors who followed a ''buy-and-hold'' strategy.
4 Over the past forty-nine years the market has risen in thirty-three years, been even in three years, and declined in only thirteen. Thus, the odds of being successful when you are in cash rather than stocks is almost three to one against you.
5 An academic study concludes that a market timer would have to make correct decisions 70 per cent of the time to outperform a buy-and-hold investor.
John Bogle
1 In 30 years in this business, I do not know anybody who has done it successfully and consistently, or anybody who knows anybody who has done it successfully and consistently. Indeed, my impression is that trying to do market timing is likely not only not to add value to your investment program, but also to be counterproductive.
Gerald Loeb
1 You should review your investments at least once a year to see if you have any weaklings that need weeding out. But ducking in and out of the market for short term gains should be left to the hardened professionals.
Peter Lynch
1 The person who never bothers to think about the economy, blithely ignores the conditions of the market, and invests on a regular schedule is better off than the person who studies and tries to time his investments, getting into stocks when he feels confident and out when he feels queasy.
2 All the major advances and declines have been surprises to me.
Philip Fisher
1 Short term price movements are so inherently tricky to predict that I do not believe it is possible to play the in and out game and still make the enormous profits that have accrued again and again to the long term holder of the right stocks.
Scott Johnston
1 We stay fully invested at all time. For 20 years I haven't known of anyone who can consistently and accurately time the market.
Mark Mobius
1 No one knows if we are in a bear or a bull market until the price movements are over and that is of no interest to anyone who is trying to time the markets. The key, of course, is not to time the market and to take a long view. If you are trying to predict whether the last four weeks are the early stages of a bear market which will then warn you to get out of the market then you are taking the wrong view. Unless you have a five-year view, the chances of you making a mistake are very great.
Index trackers
For most private investors, the best way to invest in shares is to buy index trackers.
Private investors who do not have the time or inclination to study several investment books and research shares in depth do not have the slightest chance of beating the market over the long term using their talent, intuition, etc for selecting individual shares or by investing on the basis of tips. They would be better off betting on the races or engaging in similar gambling pursuits where they would at least know the odds and get the results quickly.
Even most professional investors are unable to beat the market other than for a few years and that too by chance only, in the same manner as flipping a genuine coin can result in a series of heads or tails though each flip has an equal chance of being a head or a tail. Many years ago, professional investors could beat the market because they were buying and selling from private investors who still had shares that accounted for a significant proportion of the market capitalisation. Also market transparency was lax and insider trading was rampant. But as the holdings of the private investors decreased and professional investors holdings became most of the market capitalisation and market transparency and insider trading rules were implemented (albeit with a lot still to be desired), professional investors found it very difficult to beat the market because they became the market. It became a zero sum game for them because for every purchase and sale, the counter party was another professional investor and all such investors received share price moving information simultaneously from the company. The markets dominated by professional investors with equal access to information became much more efficient and it became very difficult to find mispriced shares. That is why, of the hundreds of actively managed collective investments, only a tiny proportion of professional investors can boast a record of outperforming the indices in the long run. And it is impossible to know who that tiny proportion are and invest in the collective investments managed by them because they can be identified only in hindsight.
Most index tracking investments are unit trusts and exchange traded funds. When buying index tracking unit trusts, check that the tracking error is insignificant and then select the one that has the lowest total expense ratio (TER). You will find this information easily at the respective web sites. When selecting an exchange traded fund check the spreads at different times in the day - they can be quite wide for some ETFs.
Even the few investors who can boast track records of beating the index in the long run and the academics who have made rigorous studies of the performance of fund managers, advise private investors to invest in index funds rather than try to beat the market by stock picking:
Warren Buffett
- Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific business nevertheless believes it is in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals.
- Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.
- Stocks are the things to own over time. Productivity will increase and stocks will increase with it. There are only a few things you can do wrong. One is to buy or sell at the wrong time. Paying high fees is the other way to get killed. The best way to avoid both of these is to buy a low-cost index fund, and buy it over time. Be greedy when others are fearful and fearful when others are greedy, but don't think that you can outsmart the market.
- Very few people should be active investors.
Burton Malkiel
- The message of the original edition was a very simple one: investors would be far better off buying and holding an index fund than attempting to buy and sell individual securities or actively managed mutual funds. Now over 35 years later (in 2007), I believe even more strongly in the original thesis. An investor with $10,000 at the start of 1969 who invested in Standard & Poor’s 500-Stock Index Fund would have a portfolio worth $422,000 by 2006, assuming that all dividends were reinvested. A second investor who instead purchased shares in the average actively managed fund would have seen his investment grow to $284,000.
- Even Benjamin Graham came to the conclusion that fundamental security analysis could no longer be counted on to produce superior investment returns. Shortly before he died in 1976, he was quoted in an interview in the Financial Analysts Journal as follows: I am no longer an advocate of elaborate techniques of security analysis in order to find superior values opportunities. This was a rewarding activity, say, 40 years ago, when Graham and Dodd was first published; but the situation has changed, . . . [Today] I doubt whether such extensive efforts will generate sufficiently superior selections to justify their cost. . . . I'm on the side of the ''efficient market'' school of thought. Peter Lynch, just after he retired from managing the Magellan Fund as well as the legendary Warren Buffet, admit that most investors would he better off in an index fund rather than investing in an actively managed equity mutual fund.
Benjamin Graham
- Since anyone - by just buying and holding a representative list - can equal the performance of the market averages, it would seem a comparatively simple matter to "beat the averages"; but as a matter of fact the proportion of smart people who try this and fail is surprisingly large. Even the majority of the investment funds, with all their experienced personnel, have not performed so well over the years as has the general market.
- Over a ten-year period the typical excess of stock earning power over bond interest may aggregate 50% of the price paid. This figure is sufficient to provide a very real margin of safety - which, under favourable conditions, will prevent or minimize a loss. If such a margin is present in each of a diversified list of twenty or more stocks, the probability of a favourable result under "fairly normal conditions" becomes very large. That is why the policy of investing in representative common stocks does not require high qualities of insight and foresight to work out successfully. If the purchases are made at the average level of the market over a span of years, the prices paid should carry with them an adequate margin of safety. The danger to investors lies in concentrating their purchases in the upper levels of the market, or in buying nonrepresentative common stocks that carry more than average risk of diminished earning power.
Robert H Jeffrey:
- To the extent that the market is mostly efficient, we can expect only modest improvements in portfolio returns from active asset management.
- [A client] asks if we can recommend a large-cap manager for him. I said, I’m going to save you some money. Don’t buy a manager, buy the index.
Merton Miller
- I favour passive investing for most investors because markets are amazingly successful devices for incorporating information into stock prices.
William Sharpe
- Active management is something you do with your “mad money”.
Rex Sinquefield
- Peter Tanous describing Sinquefield’s approach: Thus, active investment is a waste of time. You are far better off they say, spending your time, energy, and money deciding what types of stocks you want to buy, and then buying those index funds that correspond to the types of stocks you have chosen.
- There have been loads of scientific studies looking for evidence that can tell successful managers based on prior records. These studies do not meet with success. There is just no reliable evidence that there is persistence in professional manager performance.
Wait for the real bargain
Investors are often too eager to invest surplus funds. Unless the funds are being drip fed into a tracker, it would pay to be patient and stay in cash till a real bargain is available. Jumping in and out of shares handicaps your performance not only because of the trading costs but also because of increased probability of suffering losses as a result of the impatient purchases of shares that research would have revealed to be not real bargains after all.
Markets price shares correctly most of the time, based on the available information. If you think that a share is a bargain at the market price, the chances are that you have not researched the share sufficiently. On further research you will usually find that "cheap" shares appear to be bargains because there are good reasons. They probably have higher risks and / or lower growth prospects than you had initially assumed.
The time that you are most likely to find bargains is when there is huge uncertainty. For example, at the time of writing, no one knows how much the eventual costs will be to Barclays for their exposures to sub-prime mortgages, CDOs, warehoused leveraged finance debt, etc. In hindsight, Barclays may prove to be a bargain. However, it is also possible that even the current relatively lowly rating of Barclays may not be low enough.
Here's what successful professionals have to say about it:
Warren Buffett
1 The market is reasonably efficient much of the time.
2 In an investment lifetime it’s too hard to make hundreds of smart decisions. We adopted a strategy that required our being smart – and not too smart at that – only a very few times. Indeed, we’ll now settle for one good idea a year.
3 Our stay-put behaviour reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.
Gerald Loeb
1 The bargains are not available except occasionally. The opportunities will not be available when securities are generally popular and eagerly bought. It should be axiomatic that the successful investor will keep his capital idle in times of popular over-investment and over-confidence. He will be sorely tried at times when profits and income are seemingly easy to procure.
2 I consider myself very lucky if once every year or two I can find in conjunction all the elements that make for an ideal stock purchase.
3 It is true that cash has lost purchasing power … but at a very slow rate compared to the rapid depreciation that can be suffered in a real stock market decline.
4 Willingness and ability to hold funds uninvested while awaiting real opportunities is a key to success in the battle for investment survival.
Jim Rogers
1 One of the best rules anyone can learn about investing is to do nothing, absolutely nothing, unless there is something to do.
Peter Lynch
1 When in doubt, tune in later.
2 If you can’t find any companies that you think are attractive, put your money in the bank until you discover some.
3 I’m not saying that you can wake up today and look around and the average person is going to find a good stock. Maybe once every year, or once every two years, or maybe once every six months you want to be able to find one of these.
Charles Ellis
1 Make fewer and better investment decisions.
2 Quoting Tommy Armour (tennis coach): (i) Simplicity, concentration and economy of time and effort have been the distinguishing features of the great players’ methods, while others lost their way to glory by wandering in a maze of details. (ii) Play the shot you’ve got the greatest chance of playing well.
Behavioural finance
I have no doubt that psychology plays a huge part in determining market prices. Fear and greed drive prices away from their intrinsic values. However, while it is interesting to understand how investors behave in different circumstances and why they behave that way, behavioural finance cannot be used directly to make money. Nevertheless, an understanding of behavioural finance helps to avoid some irrational decisions. Some of the findings of behavioural finance are:
- Investors under-react to new information. Their prejudices prevent them from changing their minds quickly. That contributes to a delay between new information becoming available and the price adjusting to the full extent.
- Growth shares are more susceptible to fear and greed than value shares.
- General moods of pessimism and optimism as in bear and bull markets cause prices to be under or over their intrinsic values.
- Investors generally are not comfortable behaving differently from the majority.
- Investors tend to rationalise chance events and assume that these could have been predicted with foresight.
- Investors use simple rules that may have worked in the past but do not recognise when conditions have changed that make these rules invalid.
- Investors tend to extrapolate from historical data and assume that the trend will continue.
- Investors are influenced by whatever they paid for the share and are reluctant to take losses though the conditions may have changed.
- Investors sometimes gather a lot of irrelevant information and then get the mistaken belief that they have researched the company thoroughly. They are unable to discern the crucial bits that will drive the price.
- Investors tend to sell winners too quickly to hasten the feeling of pride at having bought a winner and sell losers too slowly to avoid as long as possible the feeling of regret at having bought a loser..
- Investors focus on the available information and do not think sufficiently about the risks of not considering the unavailable information.
- Investors tend to overweight recent information and underweight long-term tendencies.
Contrarian investing
A lot of money can be made if you make investments that are contrary to the current sentiment, if and when eventually the sentiment changes to agree with yours. But mindless contrarianism that simply thinks in opposite terms from the consensus will not pay off. You have to know something that the market does not know or your interpretation of known information must be better. It is unlikely that you would know something that the market does not know and insider trading is illegal. However, it is possible to interpret known information differently, specially when irrational greed and fear grip the market and the interpretations result in exaggerated valuations.
Many successful investors are contrarians. I give below quotes from some of them:
Anthony Bolton
- It's very unusual to see a significant anamoly and at the same time the catalyst that will correct it.
- 1 It has gotten easier to beat the market, not harder, over the last five years. The reason is that, in some sense, the market has gotten more irrational and random. There are a lot of new players out there, especially on the momentum side, who create great disparities and huge volatility in the market. You can notice that, with stocks up 50% or down 50%, in one day. Those become opportunities. From volatility emerges opportunity.
- If you look back over the years, you will note that the times when the gloom was the thickest invariably turned out to have been the best times to buy stocks. Maybe they will continue to decline a while longer after you buy them, but you are not likely to be able to know when the bottom has been reached. So your best bet is to pick a level you are willing to pay and proceed with part of your investment funds. If they go lower, you can buy more at even better prices. If they turn and go up, then you will make a profit on what you have.
- Even though the business may have economic characteristics that are stable, Mr Market’s quotations will be anything but.
- The speed at which a business’s success is recognised is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. Delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.
- The smart investor – the one who does not consider himself to be a financial genius but trains himself to analyse the newspapers and television and to pick tops and bottoms by the extremes in the public’s attitudes – learns to buy fear and panic and to sell greed and hysteria.
- When during a bear market he would read in the papers that the market was down to new lows and the experts were predicting further drops, he would buy safe, high yielding stock. Then, a few years later, when the prophets were predicting new highs, he would sell all. During a market rise, you can sell too soon and make a profit, sell at the top and make a very good profit, or sell on the way down and still make a profit. So, with so many profit probabilities in your favour, the best cost price possible is worth waiting for. He taught me that you can’t be buying stocks every month and make a profit any more than you could plant rice every month and make a crop.
- Any investment policy followed by all naturally defeats itself. Thus the first step for the individual really trying to secure or preserve capital is to detach himself from the crowd.
- A decline in stocks is not a surprising event, it’s a recurring event. If you live in a cold climate, you expect freezing temperatures, so when your outdoor thermometer drops below zero, you don’t think of this as the beginning of the next Ice Age. You put on your parka, throw salt on the walk, and remind yourself that by summertime it will be warm outside.
- A stock market decline is as routine as a January blizzard in Colorado. If you’re prepared it can’t hurt you. A decline is a great opportunity to pick up the bargains left behind by investors who are fleeing the storm in panic.
John Neff
- Windsor’s roller coaster experience with Citi underscored a crucial point: judgment and fortitude were our prerequisites. Judgment singles out opportunities, fortitude enables you to live with them while the rest of the world scrambles in another direction.
- To us, ugly stocks were often beautiful.
- You have to be willing to hang in when prevailing wisdom says you are wrong. That’s not instinctive; more often than not it goes against instinct.
- Windsor participated at first in the glory of dubious growth stocks. Windsor rode the stocks too long and got killed. Worse, panicked management sold its beleaguered growth stocks at the bottom and shovelled the proceeds into “safe” stocks. You don’t bounce back by owning highly recognised goods.
- You have to distinguish misunderstood and overlooked stocks selling at bargain prices from many more stocks and lacklustre prospects.
Paul F Miller
- What worked well in the past is presented as a prescription for the future. In fact, such prescriptions may work for a while and gain a large fan club which ultimately carries some specific concepts to an extreme and then to its downfall, as demonstrated dramatically by the so-called growth stocks of the 1960s.
Richard Driehaus
- There are times when our style is out of favour, and this was definitely one of those. After the first half of the year, I could see our style beginning to work again as some of the stocks we had sold earlier started reversing and turning up. We reversed our position and bought back stocks we had recently sold. And that’s what a lot of money managers don’t do.
Philip Fisher
- Doing what everybody else is doing at the moment, and therefore what you have an almost irresistible urge to do, is often the wrong thing to do.
Tim Bond (Barclays Equity Gilt Study)
- After periods of high volatility, equities become cheaply valued, from which point they then deliver excess returns.
- Behavioural economics shows that investors’ desired risk/return profile is not evenly distributed, exhibiting a much greater sensitivity to losses than might be expected. Such innate caution most probably results in an overweighting of loss probabilities, in turn giving rise to the excessive equity risk premium. The bias is likely to be hardwired into humans as part of a package of reflex reactions to danger that would have provided survival benefits during the early years of human evolution. A well-considered cost/benefit analysis of the probability of being eaten by a nearby predator is unlikely to be an effective survival technique in comparison with running very fast at the first sign of danger. In short, humans are biased by evolution to overreact to danger, since such over-reactions would have generated higher survival – and hence gene succession – rates in the past. And since early human culture was tribal or familial, we are also programmed to react to secondary danger signals in the shape of the behavioural patterns exhibited by other members of the social unit. In short, we are programmed to find panic – and indeed the opposite condition of complacency – infectious. However, while panic may indeed be an appropriate survival technique for the savannah, it does not translate entirely happily to the financial jungle.
Warren Buffett
- Irrationally low prices will periodically be attached to solid businesses.
- Moves like that, however, are what portfolio insurance tells a pension fund .... to make when it owns portions of enterprises such as Ford or General Electric. The less these companies are being valued at, says this approach, the more vigorously they should be sold. As a "logical" corollary, the approach commands the institutions to repurchase these companies ... once their prices have rebounded significantly. Considering that huge sums are controlled by managers following such Alice-in-Wonderland practices, is it any surprise that markets sometimes behave in aberrational fashion?
- Many commentators, however, have drawn an incorrect conclusion upon observing recent events: They are fond of saying that the small investor has no chance in a market now dominated by the big boys. This conclusion is dead wrong: Such markets are ideal for any investor - small or large - so long as he sticks to his investment knitting. Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves. He can be hurt by any such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times.
- The most common cause of low prices is pessimism - sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.
- None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular: a contrarian approach is just as foolish as a follow-the-crowd strategy.
- Occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.
- Those who invest only when commentators are upbeat end up paying a heavy prices for meaningless reassurance.
William Bernstein
- High previous returns usually indicate low future returns, and low past returns usually mean high future returns. The rub here is that buying when prices are low is always a scary proposition. The low prices that produce high future returns are not possible without catastrophe or risk.
- The most profitable thing we can learn from the history of booms and busts is that at times of great optimism, future returns are lowest; when things look bleakest, future returns are highest.
- If investors think that returns will be higher in Australia than in Belgium, then capital will flow from Belgium to Australia. This will depress prices in Belgium, which, in turn, will increase future returns. The opposite will occur in Australia. Prices will adjust to the point where the expected returns, adjusted for risk, in both nations will be the same.
- Because of society’s dysfunctional financial behaviour, a rising stock market lowers the perception of risk, decreasing the discount rate, which drives the prices up even further. The same thing happens in reverse.
- Good companies are generally bad stocks, and bad companies are generally good stocks. The average investor equates great companies, producing great products, with great stocks. And there is no doubt that some great companies, like Wal-Mart, Microsoft, and GE, produce high returns for long periods of time. But these are the winning lottery tickets in the growth sweepstakes. For every growth stock with high returns, there are a dozen that, within a very brief time, disappointed the market with a lower-than-expected earnings growth and were consequently taken out and shot.
Directors' buying and selling
It appears logical to assume that directors know better than outsiders about the company and its prospects. However, in practice, trying to profit from following directors' dealings is unlikely to be successful. In 1993 a unit trust called The Ely Place BRI Directors Dealings was set up to exploit opportunities flagged by directors dealings. Its performance was very poor and was wound up five years later when it was ranked 154 out of 160.
Bubbles
The market does a good job at valuing shares based on the available information. But, once in every few years, the market behaves in an irrational way.
While the internet bubble was developing, I wrote the following in a post on Motley Fool All UK Shares board on 28/11/99 (I think you may still find it there). The bubble burst a little over a year later causing severe losses to many.
"Charles Kindleberger wrote a history of financial crises under the above title [Manias, Panics, and Crashes]. He thinks that financial manias and panics follow a consistent pattern [my thoughts in brackets]:
1.The upswing starts with an opportunity - new markets, new technologies, etc that promise investors large returns. [This time the massive riches that will be generated by the internet?]
2.This attracts more and more investors resulting in rising prices and people invest everything they have and borrow to invest even more. [The second most hits on the internet are for financial sites. I find the Investors' Chronicle and FT being sold in my local Tesco. New investment magazine titles hit the news stands and TV programmes on investments have become popular.]
3.In the manic phase, investors become desperate to get out of cash and into the sort of assets that they see making other people rich. "... a larger and larger group of people seeks to become rich without a real understanding of the processes involved." [People who have made some quick money following some method in these sort of conditions think that they have "discovered" some infallible method. Some give up their jobs to become full time traders or "investors".]
4.Eventually prices stop going up. The truth dawns that the prices are too high to be justified by fundamentals. People with debt are forced to sell resulting in prices going down. [Prices cannot go up at this rate for long. Expectations will eventually align with reality.]
5.Then the bubble bursts and there is panic. People scramble to unload whatever they have bought at greater and greater losses and cash becomes king. [Those who have borrowed to "invest" have no choice; they have to sell to meet their repayment obligations.]
Nobody can predict the short term trend of the markets. Those who try often turn bearish too early and get very badly squeezed. However, as George Santayana (philosopher) said, those who do not learn the lessons of history are condemned to repeat it."
Most investors would have heard of famous bubbles like the South Sea Bubble. Burton Malkiel, in his classic "A random walk down Wall Street" provides an entertaining account of various bubbles of more recent times:
1 The "tronics" boom when electronics company stocks were the fashion and even some non-electronic companies contrived to have some version of "tronics" in their name to boost their stock prices.
2 The conglomerates boom where the magic word was "synergy".
3 Concept stocks where all that was needed for the price to soar was a good story.
4 The "nifty fifty" or "one-decision" stocks where you buy excellent companies, whatever the price, and hold forever.
5 The new issues craze where companies with names linking them to new fields like microelectronics were in huge demand irrespective of price.
6 The biotechnology boom. In the 1980s some biotech stocks sold at 50 times sales (yes, sales - not profits).
7 The Japanese land and stocks bubble. This became so big that "the Japanese could have bought all all the property in America by selling off metropolitan Tokyo. Just selling the Imperial Palace and its grounds at their appraised value would have raised the cash to buy all of California".
8 The internet bubble. It was though that the internet would revolutionise business. It did, but it did not mean that "investors" who paid ridiculous prices for any company that smacked of the internet would get rich. As in many emerging technologies, it is the consumer who benefits and most of the companies at the forefront of the technologies never make it.
One common theme about all these bubbles is that there were always new theories to justify the high prices and the belief that things were different this time.
- The sub-prime mortgages that undermined our great banks were written on the false assumption that what had been seen before would, more or less, persist into the future: housing prices would keep rising, defaut rates would stay within a forecast range, hedging strategies that worked hitherto would keep on working. That kind of thinking has led to every financial bubble in history...
- The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities - that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future - will eventually bring in pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There's a problem though: They are dancing in a room in which the clocks have no hands.
- What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising birdless bushes [WB was writing about Aesop's "bird in hand is worth two in the bush" earlier in the 2000 letter to shareholders], promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their own friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed to making money off investors rather than for them. ... But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street ... will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.
Size
If you do not have much money to invest, you could turn it to your advantage by concentrating on small companies. These tend to be less will researched than large companies and so it is easier to find bargains here. But be aware of the spreads. Even at normal times they can be quite high but they become very high when unexpected news that moves the price is released. And the normal market size (or lack of it) may not allow any substantial investments at the quoted prices.
I made quite a lot of money relative to the capital that I then had by following small growth companies. Fortunately for me, they became the rage at one time when Jim Slater popularised PEGs and provided information for the private investor to use it by subscribing to Company REFS.
I am now no longer interested in anything other than FTSE100 and a few large mid-cap companies as the normal market size of the smaller companies is too small to enable me to make a worthwhile investment in them. However, for those who have less capital to invest, I give below quotes that suggest that investing in smaller companies may be to the advantage of investors with less capital:
Buffet
a A fat wallet is the enemy of superior investment results. Though there are as many good businesses as ever, it is useless for us to make purchases that are inconsequential in relation to [our] capital.
Lynch
a When Magellan grew into a medium-sized fund, it got harder for me to make a meaningful investment overnight. Once in a while I got the chance to gobble up a huge block of shares from an institutional buyer, which is how I acquired.... But these were the exceptions to the rule of constant nibbling. Every time the fund got bigger, I had to add to each position to maintain its relative weight versus the other stocks in the fund. With the smaller stocks specially, it sometimes took months to acquire a decent amount. If I bought shares too rapidly, my own buying would cause the price to increase beyond the level at which I would have wanted to start selling.
b Bigger funds are forced to limit themselves to the top 90 to 100 companies out of the 10,000 or so that are publicly traded. That cuts out a lot of opportunities, especially in the small fast-growing enterprises that tend to be tenbaggers.
O’Shaughnessy
a Small-cap mutual funds justify their investments with academic research showing that small stocks outperform large ones, yet the funds themselves cannot buy the stocks that provide the lion’s share of performance because of lack of trading liquidity.
Michael Price
a The market gets closer to being efficient when it involves more normal, well followed large cap stocks.
Stephen Lofthouse
a Studies show that stocks followed by few analysts or held by few institutions outperform by a wide margin. Given the limited diversification of private investors, the extra return from neglected stocks may be a reward for both unsystematic risk and systematic estimation risk. Investors who buy a basket of neglected stocks will get an investment free-lunch.
Charles Ellis
a Be sure you are playing your own game.
b Admiral Morrison: Impose upon the enemy the time and place and conditions for fighting preferred by oneself.
c Armour: Play the shot you’ve got the best chance of playing well.
d Market liquidity is a liability rather than an asset, and institutional investors will, over the long term, under-perform the market because money management has become a Loser’s Game.
Concentrate or diversify?
I think the answer to this one is that it depends on you and what you are buying. If you are sure that you know what you are doing, then you might wish to buy only a few well researched investments. However, even if you know what you are doing and you understand the investment, you should spread your risks if the investment is inherently high risk, e.g. venture capital type investments.
Some investors use "forced displacement". This involves limiting the number of shares owned to a small number. If a new share is to be added, they do so by selling a share presently held. Laura Sloate, Scott Johnston and Foster Friess all limited the number of their holdings through forced displacement.
I give below some quotes regarding this topic from very successful investors:
John Maynard Keynes
1 As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. . . . One's knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.
2 I believe now that successful investments depends on three principles:
(i) A careful selection of a few investments (or a few types of investment) having regard to their cheapness in relation to their probable actual and potential intrinsic value over a period of years ahead and in relation to alternative investments at the time
(ii) A steadfast holding of these in fairly large units through thick and thin, perhaps for several years, until they have fulfilled their promise or it is evident that they were purchased by mistake
(iii) A balanced investment position, i.e. a variety of risks in spite of individual holdings being large, and if possible opposed risks (e.g. a holding of gold shares among other equities, since they are likely to move in opposite directions when these are general fluctuations.
Laura Sloate
1 Focus is the key to success. Why do Warren Buffet and Peter Lynch do well? Because they have their niches and they stick to them. They may evolve them over time.
Gerald Loeb
1 Diversification is a necessity for the beginner. On the other hand, the really great fortunes were made by concentration.
2 Confining yourself to situations convincing enough to be entered on a relatively large scale is a great help for safety and profit. Concentration of investments in a minimum of stocks insures that enough time will be given to the choice of each so that every important detail about them will be known.
3 Confining oneself to situations convincing enough to be entered on a relatively large scale is a great help to safety and profit.
4 Once you attain competency, diversification is undesirable.
5 Only the best is bought at the best possible time. Risks are reduced in two ways – first by the care used in selection, and second, by the maintenance of a large cash reserve.
Peter Lynch
1 There don’t have to be more than 5 companies in the portfolio at any one time.
2 Follow five or six companies and know these companies very well. But if none of them is attractive, don’t own any of them.
3 The best stock to buy may be the one you already own.
4 Lynch: “It only takes a couple of big winners in a decade to make the effort worthwhile. The smallest investor can follow the Rule of Five and limit the portfolio to five issues. If just one of those is a 10-bagger and the other four go nowhere, you’ve still tripled your money.” (Lynch held many stocks in Magellan because of Magellan’s size.)
Charlie Munger
1 Winners bet big when they have the odds – otherwise they stay out.
John Neff
1 I want to create impact by taking outsized positions where I saw promising returns.
James O’Shaughnessy
1 Researchers J L Evans and S H Archer found most of the benefits of diversification come from as few as 16 stocks. Subsequent research confirms their findings. You also want to avoid holding too many stocks. This can lead to diworsification.
Richard Driehaus
1 We concentrate our portfolios.
Roger Murray
1 Do intensive analytical work on a limited number of companies. I would rather have, and I will get better results, from a dozen companies that I really understand.
Scott Johnston
1 I think you own it and you love it, or you don't buy it. In order to buy a new name, you've got to kick out an old name. That imposes a discipline to always focus on the strongest names in your portfolio. What you're doing all the time is focusing on the very best companies, the very best names.
Jim Slater
1 Private investors know that, even with a portfolio of ten shares, their first choice is better than their tenth. This is an edge over the institutions that have to invest in several shares simply because of the size of the funds managed by them. Also, limiting the number of shares gives adequate time to monitor the investments in depth.
Warren Buffet
1 Some investment strategies ... require wide diversification. Most venture capitalists employ this strategy. Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single huge bet.
2 Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific business nevertheless believes it is in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when "dumb" money acknowledges its limitations, it ceases to be dumb.
3 On the other hand, if you are a know something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favourite rather than simply adding that money to his top choice – the business he understands best and that presents the least risk, along with the greatest profit potential.
4 We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characterestics before buying into it.
Selling
Ideally, you would only have to sell when you need the cash for consumption. However, we do not live in an ideal world and there are circumstances when you should consider selling.
Probably the most common reason for selling is that you either made a mistake when you bought the share because your research was inadequate or because the circumstances of the company changed for the worse unexpectedly.
Peter Lynch
- Each new occurrence is like turning up another card. As long as the cards suggest favourable odds of success, you stay in the hand. Consistent winners raise their bet as their position strengthens and exit the game when the odds are against them, while consistent losers hang on to the bitter end of every expensive pot. Consistent winners also resign themselves to the fact that they’ll occasionally be dealt three aces and bet the limit, only to lose to a hidden royal flush. They accept their fate and go on to the next hand, confident that their basic method will reward them over time.
- We sell the stock if the reason for purchasing the stock is no longer valid.
- The first is the notion that stocks do become over-owned, over-loved, even over-adored.
- The second aspect to the sell decision is when the industry we’re investing in, or the theme we’re investing in, begins to develop some blemishes – in terms of the competitors within them. We like it when the competitors to our company are doing great. I think it’s a wonderful healthy thing to be in a trend where everybody’s doing well.
- You must sell when the news is good, but the stock seems to be losing its responsiveness to good news.
- Our reluctance to consider new information with an open mind makes it harder to recognise the flaws in our old operating premise. Instead, we tend to develop a “defensive” interpretation of new developments, and this cripples our capacity for making good judgements about the future.
- It is hard for people who reach a decision after careful analysis of their information to change their minds easily – or quickly.
- More money has probably been lost by investors holding a stock they really did not want until they could at least come out even than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realised, the cost of self indulgence becomes truly tremendous.
- What matters is not whether a loss occasionally occurs. What does matter is whether worthwhile profits so often fail to materialise that the skill of the investor in handling investments must be questioned.
- Sometimes management deteriorates because success has affected one or more key executives. More often it occurs because a new set of top executives do not measure up to the standard of performance set by their predecessors. When any of these things happen the affected stock should be sold at once.
- It sometimes happens that after growing spectacularly for many years, a company will reach a stage where the growth prospects of its markets are exhausted. From this time on it will only progress at about the same rate as the national economy does. In this instance, selling might take place at a more leisurely pace than if management deterioration had set in. Possibly part of the holding might be kept until a more suitable investment could be found.
- Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.
- You simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved. When carried out capably, an investment strategy of that type will often result in its practitioner owning a few securities that represent a very large proportion of his portfolio. This investor would get a similar result if he followed a policy of purchasing an interest in, say, 20% of the future earnings of a number of outstanding college basketball stars. A handful of them would go on to achieve NBA stardom, and the investor's take from them would soon dominate his royalty stream. To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.
- The most important thing about making money in the stock market is to realise that you’re hunting with a shotgun. So we sell immediately if our expectations are incorrect. The price you pay for holding a loser is that you allow the loser to occupy a spot in the portfolio that could otherwise be occupied by a winner! Selling is much harder than buying
It pays to be nervous when directors, specially of small companies, sell large values of their holdings.
Another warning sign is when results are delayed. As Nigel Lawson put it "Bad figures always take longer to add up than good ones".
Some investors believe in cutting their losses. This gains added significance if you are able to utilise capital gains tax losses by selling some of the loss making shares where the decision to hold or to sell is otherwise marginal.
Burton Malkiel
- I agree with the Wall Street maxim “Ride the winners and sell the losers” but not because I believe in technical analysis. With few exceptions, I sell before the end of each calendar year any stocks on which I have a loss. The reason is that losses … can offset gains you may already have taken. Thus taking losses can actually reduce the amount of loss.
- It’s not so much finding and buying the winners, it’s the ability to retreat, to sell. The question is not how many winners or losers you have, but how much do you make on your winners and how quickly do you cut your losses. Seventy percent of our trades could be losing trades, but if the winning 30% are large enough to overcome losses you could still show great returns. I would rather err on the side of discretion, even if we miss some of the upside.
- As a long-term investor I have found it more profitable to run profits and cut losses.
But do not rush to sell just because the price has gone up a lot.
George Ross Goobey
- In considering whether one should sell an investment it is much better to ignore the price paid and to endeavour to judge the future of the company on the facts of the situation in which the original cost of your investment plays no part whatsoever.
- This brings us to another line of reasoning so often used to cause well-intentioned but unsophisticated investors to miss huge future profits. This is the argument that an outstanding stock has become overpriced and therefore should be sold.
- In this era of unlimited human wants and incredible markets, there is no limitation to corporate growth. If the job has been correctly done when a common stock is purchased, the time to sell is almost never.
Be patient.
Philip Fisher
- ... the need for patience if big profits are to be made from investment. It is often easier to tell what will happen to the price of a stock than how much time will elapse before it happens.
Sell if you need the cash for a better investment. But remember that a lot of bad decisions are made when switching investments.
Warren Buffett
- Sometimes the market may judge a business to be more valuable than the underlying facts would indicate it is. In such a case we will sell our holdings. Sometimes, also, we will sell a security that is fairly valued or even undervalued because we require funds for a still more undervalued investment or one we believe we understand better. We need to emphasize, however that we do not sell holdings just because they have appreciated or because we have held them for a long time.
- The trader who is always looking for “action” in the market will usually jump from one stock to another during the course of a bull movement only to find at the end that he has made far less money than he would have made by putting his money in 10 or 12 carefully chosen issues at the beginning and holding them.
Some investors deliberately limit their holdings to a specific number of shares. So, if they come across an opportunity that is significantly better than what they hold they will buy the former and sell the latter. This is termed "forced displacement". Laura Sloate, Scott Johnston and Foster Friess all limited the number of their holdings through forced displacement. Jim Slater said "Private investors know that, even with a portfolio of ten shares, their first choice is better than their tenth. This is an edge over the institutions that have to invest in several shares simply because of the size of the funds managed by them. Also, limiting the number of shares gives adequate time to monitor the investments in depth".
Some investors do sell when they feel that the shares are over valued, and in some cases merely near full valuation.
Van Schreiber
- You must sell when the news is good, but the stock seems to be losing its responsiveness to good news.
- If a big mutual fund loads up and shoots the stock price up, it may become way overvalued. We’ll sell into the buying frenzy, capture the profit, and come back later.
- We sell if it gets way overvalued. If a big mutual fund loads up and shoots the stock price up, it may become way overvalued. We'll sell into the buying frenzy.
- You have to sell not when they're fully valued, but when they're close to fully valued. To be candid, most sales in a bull market have been good intellectual sales, but the stocks really haven't gone down. So I'm really converting a piece of paper to cash.
Sell if you are constantly worrying about your investment. Maybe you did not understand your attitude to risk. In the market, you either eat well or you sleep well. In this case, sell down to your sleeping point.
John Ballen
If you have an investment where you need to be calling the management on a daily basis to find out how the business is, that's probably not something you should be investing in. You should have enough confidence in the longer term promise of the investment. You shouldn't really care about this year's Christmas sales. You should be investing in companies where if Christmas is bad, you would be thinking, that's a wonderful opportunity to buy more stock.
There are mixed views on the use of stop losses.
Scott Johnston
Third, and generally most important, we sell the stock if the relative price strength begins to diminish. We found out that stuff leaks out of companies.
Laura Sloate
Improve what you know, always keep improving but stay with it. 1990 was a rough year and we learnt some things. One is, don’t let your losses run. What we do now is, barring an October ’87 crash, or a Gulf War kind of situation, if a stock goes down 15%, we look at it and rethink our assumptions.
Burton Malkiel
The filter method is what lies behind the popular "stop-loss'' order favoured by brokers, where the client is advised to sell his stock if it falls 5 percent below his purchase price to ''limit his potential losses.'' Exhaustive testing of various filter rules based on past price changes has been undertaken. The percentage drop or rise that filters out buy and sell candidates has been allowed to vary from 1 percent to 50 percent. The tests covered different time periods from 1897 to the present and involved individual stocks as well as assorted stock averages. Again, the results are remarkably consistent. When the higher transaction charges incurred under the filter rules are taken into account, these techniques cannot consistently beat a policy of simply buying the individual stock (or the stock average in question) and holding it over the period during which the test is performed. The individual investor would do well to avoid using any filter rule and, I might add, any broker who recommends it.
Gerald Loeb
1 I know that people who will watch their losses and cut them short and I know that people who will watch their profits and when they tend to diminish, begin to take some of them, will fare the best in the long run. It over-shadows almost any other investment principle that I know.
2 The buying or selling power of the “public” once on a stampede is almost beyond calculation, and the fact that they are probably doing an eventually costly thing does not in any way decrease the loss in fighting the trend or make up for possible profits in not taking advantage of it. (George Soros said the same thing on a TV interview. He said even he would be trampled if he tried to buck the trend.)
3 There is nothing more difficult to practice than accepting losses. This is specially important because there are bound to be times when you sell something and it turns right around and goes up. There is only one way to look at it and that is to think of the costs of selling at the wrong time as comparable to an insurance premium.
4 Cutting losses is the one and only rule of the markets that can be taught with the assurance that it is always the correct thing to do. The most important single thing I learned is that accepting losses promptly is the first key to success.
George Soros
I get it wrong as often as the next guy. I just realise when I'm wrong quicker.
Peter Lynch
1 The stocks that take you the farthest in the long run give you the most bumps and bruises along the way.
2 Basing a strategy on general maxims such as “Sell when you double your money”, “Sell after two years” or “Cut your losses when the price falls 10%” is absolute folly. It’s simply impossible to find a generic formula that sensibly applies to all the different kinds of stocks.
3 If a stock is down but the fundamentals are positive, it’s best to hold on and even better to buy more. If you can’t convince yourself “When I’m down 25%, I’m a buyer” and banish forever the fatal thought “When I’m down 25%, I’m a seller”, then you’ll never make a decent profit in stocks.
Warren Buffett
1 If you've thought that investment advisors were hired to invest, you may be bewildered by this technique. After buying a farm, would a rational owner next order his real estate agent to start selling off pieces of it whenever a neighbouring property was sold at a lower price?
2 Moves like that, however, are what portfolio insurance tells a pension fund .... to make when it owns portions of enterprises such as Ford or General Electric. The less these companies are being valued at, says this approach, the more vigorously they should be sold. As a "logical" corollary, the approach commands the institutions to repurchase these companies ... once their prices have rebounded significantly. Considering that huge sums are controlled by managers following such Alice-in-Wonderland practices, is it any surprise that markets sometimes behave in aberrational fashion?
3 Even though we had bought some shares [in Wells Fargo] at the prices before the fall, we welcomed the decline because it allowed us to pick up many more shares at the the new panic prices. Investors who expect to be ongoing buyers of investments throughout their lifetimes should adopt a similar attitude towards market fluctuations; instead many illogically become euphoric when stock prices rise and unhappy when they fall.
Some reasons when not to sell are given by Peter Lynch:
1 Lynch (in among “the 12 silliest things people say”): “It’s taking too long for anything to happen.” Most of the money I make is in the third or fourth year that I have owned something.
2 Do not sell merely because the price has gone up. Lynch calls this “pulling out the flowers and watering the weeds”.
3 Do not sell in anticipation of a crash. Lynch: “A decline in stocks is not a surprising event, it’s a recurring event. If you live in a cold climate, you expect freezing temperatures, so when your outdoor thermometer drops below zero, you don’t think of this as the beginning of the next Ice Age. You put on your parka, throw salt on the walk, and remind yourself that by summertime it will be warm outside.”
4 There is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of the newscasters. Sell a stock because the company’s fundamentals deteriorate, not because the sky is falling.
5 When you sell in desperation, you always sell cheap.