My pet peeves in Investing
Investment principles I believe in, framed the other way round...
I am generally a positive person, but I thought it might be refreshing to frame my investment philosophy and beliefs in a negative way instead of a positive way. My hope is that this will make a larger impact. The below is by no means comprehensive, and not in order of merit (but the first two points are probably the pet peeves which I encounter the most)
My pet peeves in investing:
Looking at stock prices and price charts in isolation
“Look at this stock! The stock price has gone up by so much! Let’s take profit/sell/short/wait for pullback”
“Look at the price chart! The stock price has gone down by so much! Let’s buy/hold/average down”
This would probably sound familiar to most of you, but what these statements miss completely is the relationship between the fundamentals of the stock and your expected value of the stock. The price of a stock can go up and yet the stock becomes more undervalued. The price of a stock can go down and yet the stock becomes more overvalued
If a company continues to execute and allocate capital well, grow its revenues and earnings, and expand into adjacencies with a larger total addressable market, your expected value of the company will likely go higher over time. Even though the share price has gone up, the enterprise value might have gone up even more, and thus becomes more undervalued.
Conversely, if the company does not execute well, with competition and risks that you did not previously foresee, there might be a permanent impairment of the future earnings and cash flow streams you would expect from the company. If your expected value is lower than the market price even after a large drawdown, you should consider selling the stock.
Equating a good company to a good stock
“Let’s buy Company A because it prospects are very rosy, it’s total addressable market is huge, and the company is the leader in the space. What can go wrong?
Valuation matters. You might be right on the company, but if you buy at an elevated valuation that has more than priced in its rosy prospects, your returns will most probably be sub-par. A good example is Microsoft. Bring yourself back to 1999, where Microsoft had excellent prospects and was looking to dominate the world. If you had bought the stock at $38 at the end of 1999, you would have had to wait till mid-2014 for the share price to break-even (excluding dividends). 15 years of negative price returns. Was it a bad company in 1999? No it wasn’t, but it was just trading at too high a valuation, pricing in too rosy a growth scenario. When the growth narrative didn’t deliver, or was less rosy than expected, there was a fade back in its valuation. Even though earnings from the company grew throughout the 15 years, the share price went down instead of up. Valuation matters.
You might notice that I did not argue for the converse. It is technically true as well that if you buy a lousy company at attractive valuations, you might make money when the market recognizes that the prospects of the company are not as bad as what the valuation reflects. Warren Buffett calls it the last puff of the cigar butt. I have known of very smart investors that have made money off these stocks. However, I tend to stay away from this space as it requires specific catalysts to realize the value, and time works against you here as the company is likely burning cash, losing money, selling assets at distressed levels etc..
Timing the market
I believe that most investors are not able to time the market. As cliche as it sounds, time-in the market is more important, and has historically proven to be more profitable than tim-ing the market for most investors. There are just too many macro variables and policy predictions that you have to get right to be accurate in your market timing.
To compound the difficulty, in order to be better off, you need to not only get out before the market drawdown, but also to get in before the market bounces. It is rare to get both counts right. I have seen plenty of cases where clients rejoice at getting out before market crashes, but were not able to get back in before the market bounced back. In the end, they were worst off as compared to just staying invested in the market.
Blind belief in mean reversion
There are many things in life that revert to the mean, but my belief is that stock prices do not often revert to the mean. A good company can continue to do well and exceed expectations due to certain competitive advantages that are difficult to compete away (e.g. Network effect, Intellectual Property, Brands, Regulations). A bad company can continue to burn cash and erode shareholders’ value and eventually go bankrupt. Unless you have a compelling reason why the market is mispricing a laggard, you are usually better off cutting loss. To quote Peter Lynch:
Selling your winners and holding your losers is like cutting the flowers and watering the weeds
“Why did the stock price go up/down when the earnings was bad/good?”
As mentioned above, I believe that the market is efficient to a large extent. A stock price will most likely reflect the market’s expectations of its future earnings. If the market has priced in a -10% in a company’s earnings, and the company delivered a -5% earnings print, the share price of the company will most likely react positively. Conversely, if the markets were pricing in a 30% earnings increase, and the company “only” delivered a 20% increase, the stock price will likely react negatively.
Appendix: Additional pet peeves that didn’t make it to the above list
Media using absolute numbers instead of percentages to report on price movements. For example, DOW DROPS 1000 POINTS, HIGHEST EVER IN HISTORY! This does not take the base into consideration, as the Dow Jones Index has grown substantially over the years, so a 1000 point drop is only a 3.5% decline now. For reference, the worst ever percentage drop in Dow Jones was 22.6% on Black Monday in 1987, which was “only” a 500 point drop.
Since we are on Dow Jones, why are people still using this index? It is price-weighted, which makes no sense to me as it can be distorted by share splits which have no impact on the value of the enterprise. The price of a single share of a company doesn’t mean anything in isolation.
Professional investors using Price/Sales instead of Enterprise Value/Sales. I am quite puzzled by this, as most investors understand the logic behind using EV/EBITDA and EV/EBIT, and do not use P/EBITDA or P/EBIT, but I often see investors using P/Sales. Can someone explain this to me?
The increasing popularity of actively managed funds that consist of passive vehicles. This doesn’t make sense to me. If you believe that markets are efficient, and that you want the lowest cost exposure, you buy ETFs/Index Funds to replicate that exposure. Why would you pay somebody an active management fee to manage passive vehicles for you? That doesn’t gel philosophically. You either believe in active management or not.
Equating luck with skill. Being lucky with a concentrated stock pick that performs well does not necessarily mean that you are a good investor.
If you like my writing and would like to support me, please subscribe and share with your friends!