A rule to live by: When smart people talk, listen. With regard to investing, we go a step further and put ourselves in the presence of brilliant investment thinkers as often as possible (and then we share their valuable secrets). At the CFA Institute Equity Research and Valuation Conference there were smart investors buzzing about as if the queen bee herself was set to arrive. The presenters were compelling, as expected, and provided a few notable remarks that could help your investing results become as sweet as honey.
"Stocks are cheap." Jeremy Siegel, professor at The Wharton School, University of Pennsylvania: Stocks have consistently been good investments over long periods. Professor Siegel, an avid market historian, noted that "there has never been a 20-year period in U.S. history where real returns on diversified common stock portfolio are negative." In fact, for the past 200 or so years, the average annual return (adjusting for inflation) has been 6.6% and good enough to trounce bonds (3.6%) and gold (0.7%). Yet, today, investors are frightened of stocks and the market's valuation, as shown by the Dow Jones Industrial Average (^DJI -0.39%), sits below its long-term average, which has historically predicted strong future returns. Investors would be wise to take a long-term look with their investing dollars and consider moving back into stocks.
"In valuation, we are always looking for reasons to pay too much for a company ... I say, 'Show me the money.'" Aswath Damodaran, professor of finance at NYU Stern School of Business: The proverbial truth-teller and authority of all things valuation and cash flow appeared in a half-buttoned orange and gray checkered flannel with an orange tee underneath. Damodaran is the consummate academic meets practitioner -- unassuming, quick-witted, and incisive. His plain-spoken words reveal an uncommon wisdom.
Investors are continuously obsessed with justifying investments in overrated growth stories, or value stocks doomed to become cheaper. To combat this problem, Damodaran offered a simple piece of advice: "Ask yourself, what makes sense?" Translated: What variables are most likely to affect a company's ability to bring home the bacon? For companies generating incredible profitability, valued as if they'll grow to the size of the Indonesian economy ($846.8 billion in 2011), or the presumed but unproven world-beater, common-sense questions are in order. How solid is the company's competitive advantage? Relative to its peers, can its profitability be sustained, and how large is its possible market? For Groupon (GRPN 4.55%), the obvious answer was, or is, no. Last, and perhaps most important, more detail -- and by corollary, predicting a lot of things to some incredible degree of false precision -- may actually compound the risk and magnitude of errors.
"What is priced in?" Michael Mauboussin, chief investment strategist at Legg Mason Capital: Mauboussin believes that the key to investing is to figure out what Mr. Market is pricing into a given investment and then to make your own buy or sell decision accordingly. Investing, he says, is a game of expectations, and you make money by sticking to situations where you believe the opportunities are greater than what other investors expect. But how? For one thing, you can have a more informed opinion -- if you're a fashionista, you're more likely to know whether or not premium clothier Michael Kors (CPRI -4.01%) is high-fashion or fast fad, or you may work in the retail industry and see buyer behavior. If you're numerically inclined, you can also look at the growth assumptions embedded in a stock's current price and compare that to the growth you expect.
"Most of the companies in the Russell 2000 Value are bad companies. In fact, they're probably riskier -- business risk, poor governance, too much leverage, and lack competitive advantage ..." Preston Athey, T. Rowe Price: Those were the words of one of T. Rowe's most celebrated portfolio managers, owner of a two-decades-long record of beating the market and the manager of T. Rowe Small Cap Value. Calling the market stupid, short-sighted, or otherwise out-to-lunch is a psychologically convenient explanation for contrarian-minded folks. And sometimes it's true.
But looking at the universe of small-cap value stocks writ large, Athey's observation is on the mark. They're bad companies. They lack competitive advantages. And so, the market isn't always myopic to question a company's prospects after a really bad quarter. A representative example: American Eagle (AEO -0.89%) has roared back from its 2008 lows, and in retrospect, it seems obvious. But it could've just as easily faced a decades-long stagnation a la the Gap. Likewise, that cash hoard at Nokia (NOK -0.81%) isn't worth too much if ends up giving handsets away. The point: What looks cheap sometimes isn't. Separating the wheat from the chaff -- or in certain cases, the survivors from the quickly fading -- isn't an easy task.
The Foolish bottom line
The common thread running through the advice of these market mavens is the importance of thinking. Whether thinking about the lasting effects of economic fears, competitive threats, a stock's cheapness, or embedded expectations, it pays to engage in the exercise of thinking itself.
