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100 Ways to Beat the Market: #24, #25, #26

January 11, 2012 | About:
Greg Speicher

Greg Speicher

41 followers
100 Ways to Beat the Market #24: Don’t skip the thorough analysis! Most of us do not easily part with our money. We like to think of ourselves as shrewd. We want good, reliable information before making a purchase. Yet, something interesting often happens when we decide we want something – we change from a dispassionate rational shopper to falling in love with the object we desire – particularly when there is a real or perceived scarcity factor involved. Our rationality can quickly give way to anxiety, greed and impetuousness. It is as if the brain short circuits and goes directly for the kill, as other more balanced considerations fade into the background.

It was against the backdrop of this reality that Ben Graham formulated his wise and proven approach to investing, he himself having been almost wiped out by the 1929 crash. At its heart, Graham’s approach to investing is very simple and rests on a relatively small number of timeless principles. Buffett has traditionally singled out two: The Mr. Market parable which crystallizes the proper way to think about market prices and the Margin of Safety which both minimizes the possibility of permanent loss of capital and provides a hedge against human error and ignorance.

I would argue that an equally important principle is encapsulated in Grahams definition of investing itself as found in The Intelligent Investor, to wit, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” [Emphasis added]

Now, it is said that the road to hell is paved with good intentions. No value investor worth his salt would not agree that he should do his homework before pulling the trigger on a new investment. The problem comes when that dispassionate analysis gives way to the greedy impulsiveness described above.

“This one is going to get away.” “Its about to run up in price.” “So and so has already established a large position.” “I’ll initiate with a starter position.” Man’s capacity to rationalize is limitless, and his good intentions provide flimsy guardrails. None of these reasons even remotely equates to “thorough analysis”.

Thorough analysis is part of the margin of safety. It reduces mistakes. It squeezes out luck and injects skill into the equation. It fosters conviction – the kind that really counts when prices inevitably move against you in the short or medium term.

Do not skip thorough analysis. If you got away with it in the past, consider yourself lucky and resolve never to do it again. (The funny things about markets is that they can sometimes teach the wrong lessons.) Chances are you can look back over your investing career and identify several investments where you skipped this step and lost money. In investing, just playing good defense and not having periodic material losses will go a long way to improving your long-term compounding.

Think of thorough analysis as an intergal part of investing. Resolve to not commit capital if you do not do this. Consider selling positions where you skipped the thorough analysis, or at least roll up your sleeves now and do it for all your holdings. Most skip this at their own peril and, if you do it religiously, it will go a long way towards identifying market-beating investments.

100 Ways to Beat the Market #25: Ask the right questions.

Investing is simple but not easy.

Likewise, basketball is simple but not easy. All you need to do is put a ball with a 9″ diameter into a hole with a 17″ diameter. Simple, right? That is until you have a great athlete in your face playing defense along with the pressure of performing when it really matters.

Investing is simple because all you need to do is buy a meaningful amount of a business that is selling for less that it is worth and hold on until the market recognizes its miscalculation. This is not easy because it requires a rational framework that fully respects both the intelligence and skill of your counter parties and the high degree of efficiency often present in markets, along with the emotional discipline to act rationally in the face of fear and greed.

One common error of investors is to make things too complicated. One embodiment of this is the complex financial models found in analysts’ spreadsheets. Without a grasp of the right questions and a good dollop of wisdom, these can often obfuscate as much as enlighten. There is a reason Buffett does not even use a calculator when valuing a company.

The key to being a great investor is knowing how to ask the right questions and then only investing when you can actually answer them with a high degree of certainty and conviction. You do not need to do this very often. In fact, it is probably not possible to do it very often.

When NBA rookie Derrick Williams worked out with Kobe Bryant over the summer, he asked Bryant what moves he should work on. Bryant told him it was not a question of having a lot of moves, but rather having a small number that he could actually execute and finish – that were unstoppable.

If you want to have that kind of success as an investor, spend your time figuring out the pivotal questions upon which your investing thesis is based. Eschew false precision and seek broad certitude.

Consider how Glenn Greenberg explained at Columbia how he decided to invest in Google (GOOG). Greenberg admits that there is a lot that he does not know about Google. But he does know that people now spend 30% of their time online and that 10% of advertising is done online. He is willing to bet that over the next five to ten years the percentage of advertising done online will catch up with the percentage of people’s time spent online. He does not know exactly how it will play out, but he does believe that Google, with a 50% market share in online advertising, will get its fair share.

Focus on asking the right questions – the big, broad ones that really matter. If you get these right, the answers will shakeout out into the knowable and unknowable. If you focus on investing in the first camp and have the discipline to not overpay, you are well on your way to beating the market.

100 Ways to Beat the Market #26: Buy stocks that will double in five years.

For many years, Warren Buffett’s stated goal was to increase the intrinsic value of Berkshire Hathaway (BRK.A)(BRK.B) by 15% per annum. By doing this, investors could expect Berkshire’s value – and, with time, its stock price – to double every five years. (In the Berkshire Owner’s Manual, Buffett candidly states that this is the upper limit of what investors should expect today given Berkshire’s massive amount of capital and the difficulty for any large business to compound intrinsic value at 15%.) Prem Watsa’s stated goal at Fairfax Financial is to increase book value by 15% per year.

Finding stocks that will double in five years is, I believe, an aggressive but realistic objective for an active individual investor who develops the requisite skills and works hard at it. If you achieve this goal over the long term – regardless of whether your annual returns are lumpy along the way – you can expect to soundly beat the S&P 500. Your much smaller capital base is a distinct advantage vis-à-vis large investors such as Buffett or Watsa who need to deploy billions of dollars.

What you are essentially trying to do is to figure out what a business’s shares will be worth in five years and then to look to buy them at half of that today. How you get there will be some combination of growth in intrinsic value and buying shares at a discount to intrinsic value. One example is to find a company that can grow earnings at 15% for the next five to ten years and then buy it at fair value. You then sit tight as the stock price rises in tandem with earnings growth. Another approach is to find a stable, high quality business and buy it for 50% of its intrinsic value with the expectation that, over the subsequent five years, the market will re-price the security to reflect its intrinsic value. If it happens sooner, your rate of return is even higher. Finally, there is the combination approach where your double comes not only from growth in intrinsic value, but also the closing of a valuation gap.

One more thing: however you get to your double, you should always include a consideration of certainty. One way to think of it is that your outcome will be a function of your expected return and the certainty with which you will obtain it. Ideally you want investments where the expected mathematical annual return is 15% and the certainty with which you will obtain it is near 100%. You may want to consider changes in your portfolio if you can exchange your current holdings – after consideration of taxes, if any – for ones that offer a higher expected return or a higher certainty of obtaining generally the same return as an existing holding.

There are other frameworks for beating the market, but this is a good one. It is both conceptually simple and within reach. It goes without saying that compounding at this rate over long periods can generate real wealth.

About the author:

Greg Speicher
http://gregspeicher.com/

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