From the Editor - May 05

The commentary below is from our monthly newsletter and is provided here as a convenient reference for our readers.

One of the more knowledgeable financial writers this editor follows faithfully each week is John Maudlin. Maudlin recently wrote a book called Bull’s Eye Investing, an excellent read for those of you wishing to learn more about investment trends, techniques, etc. He issues a free weekly newsletter to discuss his views of the economy. (You may subscribe at http://www.frontlinethoughts.com.) He is somewhat verbose in his newsletters, but for the patient reader he always has worthwhile insights.

In one of his book chapters on “due diligence” (i.e., that process an investor should go through to investigate a mutual fund before purchasing) he writes the following:

The most important thing to understand about a fund is “why” it makes money. If you cannot understand the “why” of a fund, you should not be investing. This is the critical question that will help you understand what the dominant factor in performance of the fund is: skill or luck. As I stated earlier, luck always runs out, typically just after you invest. More funds are based upon luck or random chance than you might think, but I can guarantee you no fund manager will admit it, and most of them would be insulted if you said so. Genius is a rising market, and good performance has persuaded more than one manager they are geniuses. Avoiding such genius is crucial to capital preservation. Finding true investment ability (genius or not) is the secret to capital growth.

The next most important question is “how” the fund makes money. What are the strategies and systems used, and what is the risk taken? If you can get a good feeling about those two questions, then you follow up with the more mundane but critical questions of “who,” operational issues, structure, safety of assets and, of course, performance.

Since many of the readers of The Prudent Investor are not aware of our investment methodology (i.e., “why” our strategy makes money), we thought this would be an opportunity to shed a little light on this (important) subject. We hope the real answer is not sheer dumb “luck” as Maudlin suggests is the driver behind many “successful” investment funds.

The following are three principles which drive investment decisions at The Prudent Investor:

1. Follow the insiders. There are many studies that show that company insiders such as board members and senior executives have a better view of a company’s future prospects over a 1-2 year horizon than outsiders. Depending on the study you read, insiders outperform the overall market anywhere from 3-10% annually. We think even a 3% outperformance represents a worthwhile opportunity and thus tend to bias our investment picks toward those stocks that have more recent insider trading (purchases) activity. Over the next year or two this will be the area of increased focus for The Prudent Investor since we believe this is one of the few remaining underexploited areas of analysis for identifying new attractive investment ideas. (Note: We follow insider trading of the legal variety and not the illegal “hot tips” that get Martha Stewart and others into trouble.)
2. Don’t overpay for a stock. A very popular investment strategy in the ‘90s, and perhaps still popular today, was the idea that one should buy the very best companies in a given industry. The company’s stock price relative to its current underlying value is of less concern since, as the theory goes, an excellent company will continue to grow earnings at an attractive rate for many years into the future and therefore continue to deliver a profitable return to investors. This unhelpful strategy has helped millions of investors lose money since 2000, and will help millions more lose money in the future. We believe you should never overpay for a stock, no matter how attractive it appears to be at the time, and no matter how many Wall Street professionals are harping its value as an investment. To say “don’t overpay for a stock” sounds easy, but it requires a certain level of analysis to determine what the company might reasonably be worth at the time of your purchase. Our ranking system for stock valuation (as shown in Table 4) helps us to bias our investment decisions toward those stocks that represent more attractive valuation levels.
3. Never buy a stock unless you know its “sell” price. The most fundamental mistake many investors make, even many seasoned investors, is to buy a stock without knowing the price at which it should be sold. To purchase a company and not know its sell price implies that the buyer does not really know what the company is worth in the first place. Our investment methodology automatically calculates a “fair value” price, which we typically use as the stock’s sell price (see Table 4). It is not necessary (nor is it possible) to be 100% accurate in your calculation of “fair value” and/or sell price. A successful investment strategy merely requires the consistent use of a reasonable means for calculating a sell price based on the underlying company valuation—even if your calculations are wrong, at least if you are consistently wrong, you will still tend to buy the stocks that are at better valuations and sell them as their valuations rise. One note, we do not recommend the method of choosing a sell price that is based on the original buy price. This may be the most common way for more novice investors to choose when to sell. “I bought it at $5/share so I’ll sell it at $10/share,” so the rationale goes. Ironically, even this strategy can work if followed consistently, but it is far more risky than choosing a sell price based on more fundamental valuation metrics. After all, perhaps $5/share should be the sell price, especially if the company runs into trouble at some point. Or perhaps the stock’s estimated fair value is $20/share and not $10. Basing sell price on some percentage of buy price runs the risk of either a) holding a stock when it is (or becomes) overvalued or b) selling a stock too soon. Having a rationally-selected sell price in mind for each of your stocks also prevents you from falling into two additional common traps. The first is selling your stock simply because it has dropped in value. When a stock falls by 20-30%, many investors begin to panic and second-guess their initial investment decision. Without an estimate of the stock’s fair value in mind, the investor is tempted to sell as well, assuming that “the crowd” must be right. The second trap that having a sell price helps you avoid is holding a stock simply because it continues to rise in value. When a stock becomes grossly overvalued, playing the “greater fool” game becomes quite risky, and subjects you to becoming the “greater fool” yourself. (The “greater fool” theory in investing says that you can buy or hold a stock that is very overvalued and sell it to someone else at an even higher price at a later date—the “greater fool” than you!)

Next month we will look at some additional investment principles that The Prudent Investor uses in selecting its stock portfolio.