Analyzing Stocks is extremely difficult – One of the greatest disservice that Peter Lynch has done with his book “One Up on Wall Street” is that he has convinced many of us that investing is easy. Just buy stocks of companies that make products that you know! But if you think about it, understanding a company is much more difficult that that. One has to understand accounting, how revenue is counted, various FASB rules about stock option accounting, pension liabilities and capital structure.
Analyzing stock is simply not about looking and comparing PE Ratios. You have to truly understand a company's business model, the products they sell, their accounting. Take banks and credit cards for example. Even the professionals who buy bank stocks did not really understand what credit derivatives were! Or how they were accounted for! If you were analyzing JP Morgan Chase, would you understand what was going on in their trading books, their loans books, their off balance sheet items or even how their Chase credit cards were doing? Look at all the research reports on AIG prior to their demise! Even Warren Buffet did not anticipate how much American Express would suffer in the crisis.
Understanding other markets – But analyzing stocks isn't simply enough. To really get a handle of how a particular stock or company is doing, one has to be aware of what other market participants are thinking, and what they are pricing into the market. Here are some examples of other markets that a stock investor has to look at.
Options Market – One often has to check what is the options of (vol) market expecting and thinking in terms of future volatility of the stock you are researching. That involves understanding options pricing and what it means.
Understanding private equity valuation – One of the keys in understanding the backstop price of the stock. To do that you really need to understand how do private equity investors value companies and how they do their analysis of what asset sales and leverage can have on potential value.
Understanding Capital Structure Arbitrage – Many savvy hedge funds employ a trading strategy called “capital structure arbitrage” in which they either go long the stock and short the debt or vice versa. They create models to find equilibrium values of both debt and equity and do arbitrage trades if they are trading out of whack. Understanding how these folks look at markets is also necessary to understanding what is really going on with the stock you are researching.
Understanding Debt Value – Very often, where a company's debt is trading is a leading indicator of how the equity is going to trade. Professional investors, hedge funds and proprietary trading desks look at both debt and stock value. It is important to understand the trajectory of a company's credit rating as well. But while the pros look at these relationships all the time, most investors simply are not aware of these things. The professionals also use credit default swap levels as a guide to how their debt is trading. Most of us do not even have access to these data.
Macro economics take a lot of work and study – Aside from the amount of information that you have to look at for an individual stock, one has to be aware of the macroeconomic environment as well. It is important to understand monetary policy, currencies etc. In fact, even very few professional investors understand macroeconomics, which was why they were so caught up by the oil spike in 2007 and 2008 and the demise of the banks in 2008. Many value investors fell into “value traps” and kept doubling down on the bank stocks that they own.
But really understanding economics is an extremely difficult thing if you have not studied the topic. Simply relying on consensus forecast isn't going to cut it. After all, no economist forecasted the near collapse of the financial system in 2008. And it is not just forecasting GDP growth that you have to understand but also knowing and understanding global central banks and monetary policies.
Asset allocation is not a set and forget thing – After writing all of the above, many would say “hey, you are right, and that is why we invest in index funds or do some simple basic asset allocation and be hands off most of the time. And that is true, the majority of us should simply invest in index funds. That is the easy part. The hard part is deciding on what your asset allocation should be. How much of your asset allocation should be in stocks vs bonds, international stocks vs domestic stocks, domestic vs international bonds. How much commodities should be in your portfolio? How much cash should you carry? How much alternative assets you should have? How often should you rebalance your portfolio?
Folks like University endowment funds hire huge staffs just to perform this function. And even then, they have their bad years.
Ending Thoughts – Investing is a really tough job. But books like “Beating the Street” from Peter Lynch and tons of others give the impression that it is easy. It is definitely not easy managing money (whether your own or others). Many folks really spend too much time on their investments or portfolio. But the truth is that those time spent is mostly futile. Only folks who are professional investors should spend all their time on the financial markets. And when I say professional investors, I mean folks like money managers, hedge fund managers etc. You may spend as much time as a successful manager on the “markets”, but the hedge fund manager is likely to make many more multiples of what you and I can make! Even then, a successful fund depends on more money being invested in the fund from investors. That is how money managers make their money. They develop a good track record and investors give them more money to manage and they make more money from fees. But the ordinary folks can have a “good year” and nobody is going to give you anything to invest! Hence, what really makes you more wealthy is how much income you make and how much you save and not really the performance of your portfolio! Focus on making more money from your career instead rather than chasing the extra 1% from your portfolio.
This was an interesting guest post is by Mr. Credit Card. While I (Investor Junkie) may not completely agree with his position, it's a more common notion to let investment professionals perform the stock picking for you via actively managed funds.
Readers what do you think? Do you think investing should be left to the professionals? Isn't it true even “professionals” rarely beat passive indexing over the long haul?