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5 Reasons to Doubt My Analysis

October 01, 2012 | About:
Daniel Sparks

Daniel Sparks

With the growing influence of securities analyst recommendations and the proliferation of financial bloggers, there is good reason to question their usefulness. Although probably not a surprise to anyone, I think it’s worth some discussion: Just because I invest in a particular stock does not mean you should invest in the same one, or vice versa. There are just too many outside factors to consider: allocation, personal conviction, available capital, time horizons, investment philosophy, circle of competence, etc. But this does not discredit the stock analysis write-ups and recommendations of financial bloggers. In fact, financial bloggers can be a great resource for your portfolio — if you approach them skeptically. So without further ado, five reasons to doubt my analysis:

1. Your investment framework differs from mine.

It’s perfectly fine for investors to have investment frameworks that differ from each other. Though I'm a huge critic of day trading, I find it beneficial to approach investing with an open mind so I can take in varied perspectives and use them to “innovate” my own. Due to his huge reliance on psychology in his day-trading success, I was compelled to read "The Inner Voice of Trading" by Michael Martin. This summarizes the underlying philosophy in the book:

"To succeed in the stock market, a trader should aim to understand his inner voice and find a trading system with which his psychological make-up is compatible."

Psychology plays a huge role in investing. Michael Martin again summarizes it well:

“Unfortunately, most aspiring traders find out far too late that the act of trading is 20% intellectual and 80% psychological.”

For this reason, individual investors often have slightly different approaches to investing, as they should. “It’s a complete fallacy to think that having a trading system will annul strong emotions,” Martin says. Therefore, individual investors should cater their investment framework to their psychological make up while still demanding rationality.

Does Michael Martin sound interesting to you? Check out my book review of "The Inner Voice of Trading."

2. Your level of conviction differs from mine.

Even if you manage to buy a stock at the same price as your favorite guru, your level of conviction regarding the pick probably differs immensely. This will, no doubt, affect your sell decision down the road and could end up costing you some serious money.

3. Your circle of competence differs from mine.

I have trouble understanding many companies. In fact, sometimes I feel stupid compared to other financial bloggers and securities analysts out there that so easily hold opinions regarding such a wide range of stocks. My knowledge is very, very limited and I am completely clueless regarding the sustainability of many different business models and industries. Stay within your circle of competence. If you don’t understand where cash is coming from, how management uses it to create value and how sustainable this stream of cash flow is, don’t invest in it — even if your favorite guru thinks it’s the hottest thing since Google.

4. Your time horizons differ from mine.

I could probably say that most value investors are long-term, buy-and-hold investors. But this does not mean we are all investing with the same time horizons in mind. An investor with only $30,000 to invest probably has a drastically different time horizon than someone with $5 million of discretionary cash, whether they realize it or not. What exactly is long-term anyway? Five years? Ten years? Five years is quite a bit different than than years. And even if we say we have a particular time horizon in mind, is that really our time horizon? Take a look at your portfolio turnover. Does it really look like your investment time horizon is greater than five years?

5. I make mistakes.

I make mistakes. In fact, I make huge mistakes. It’s part of investing in the stock market. Even if I’m making money, good outcomes do not mean that the underlying process to achieve these returns was a good one. How much risk did I take to achieve above average results? Was I lucky? Or, on the other side of the coin: When a guru does not have successful outcomes, it doesn’t mean he is a bad investor. Perhaps his process was nearly flawless and he has simply witnessed a bad string of luck. No matter how much we wish our success and failure was all dependent on skill, it’s just not the case. Luck plays a huge role in investing.

Rating: 4.2/5 (12 votes)


Ry.zamora - 1 year ago
Your reasons are very spot on, and considering the increasing online population of DIY investors and analysts, more skepticism needs to be placed. In fact, I've nothing to add to your five reasons.

However, I would like to contribute to your article on how readers can appraise others' analyses before following the recommendation to buy/sell/etc. As I spend some time poring over Gurufocus analyses (and sometimes on SeekingAlpha), I came to three ways of doing this.

1. Assess the writer's compatibility with your investment framework. Does the writer cover the same elements you look at? Is this coverage acceptable from your point of view? Does he use the same terminology you do? (For example, "funds from operations" or FFO as CFA CBOK defines it is something I usually call "operating cash flows before working capital" or OCFBWC.)

Whether charts, tables, and graphs are used or not can be an irrelevant matter, as it is a question of the thesis' thoroughness. However, such visual images are good in eliciting remarks from those who are more experienced or those who might notice something the writer didn't. Perfect for people who don't proofread or do a third, fourth review of their analyses.

2. Pay very, very close attention to the valuation model employed. If the discount rate is computed, do you think is it reasonable? How does the writer generally compute this? Furthermore, what sort of valuation models were used for the stock? Is it appropriate? Or is it incomplete? Are the assumptions reasonable, or are they insufficient for your taste?

3. Look for citation of sources. This is VERY important, especially for qualitative aspect of analyses. From experience, the sheer depth of the information provided by the writer is enough to lend credibility to whatever is being written (see works by "The Science of Hitting", for example), working on the concept "it's too specific to be misleading".

Naturally, this has its pitfalls and your best defense is to verify the information on the annual report, on Google, or get the sources straight from the writer. You'll get a response soon enough.

Of course, it goes without saying that you can always treat the analysis as a screener (be professional and cite your sources!!!), so that you can put the company through your investment framework and determine whether it passes your standards. You tend to learn more about the company this way, and you also gain the ability to regularly update valuation models that you otherwise will not have if you just read someone else's work.

I've done this with Whitney Tilson's bullish recommendation for Iridium Communications (because I disagreed with his relative valuation EV/EBITDA model) and chandancubey's series of articles on Holcim Ltd. (because I thought it wasn't thorough enough). I've also done this with Hillenbrand, Inc. after reading about it on the Motley Fool (obviously they didn't analyze it much) and Autoliv Inc. (found it being promoted on SmartMoney).

Strangely I find better opportunities this way than going through quantitative screeners, and apparently I'm not the only one: Hodges Capital (a prominent Dallas, TX equity fund) also operates in this manner.

There is no harm to your reputation if you source your ideas from other people (I have some friends in the industry as well and out of boredom I sometimes ask what companies have attracted them recently), but it is detrimental if you follow a recommendation "just because someone you respect said so"... for the reasons already outlined in the above article.

Happy investing!

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