Investing is at its best when it is most businesslike. That's what Benjamin Graham taught us. His book, The Intelligent Investor, is considered by many to be the finest on investing ever written. First penned in 1949, it remains in print today, having recently been lovingly updated by Jason Zweig.
One might think that a book considered to be the neplus ultra of investment texts would delve into the hopelessly complex and ephemeral. Instead, Intelligent Investor's stated goal is simple: to help the investor build a framework to invest in bonds and common stocks. That's it. No discussions of oscillators of any kind, no mention of relative strength, and no great insights into structured finance.
My entire investing philosophy switched when I read a single line in Intelligent Investor. It was this: "Obvious prospects for physical growth in a business do not translate into obvious profits for investors."
The translation: If you're looking to invest in companies that have, for example, spectacular growth potential, you have to make sure that this spectacular growth potential is unappreciated. If everyone knows that a company is going to grow at 15%, then that growth will be factored into today's share price. Buying the obvious doesn't necessarily lead you to the promised land. An example from Graham helps.
In 1949, the obvious growth business was passenger air travel. And, yes, Delta (NYSE: DAL ) , Continental (NYSE: CAL ) , and a host of other airlines domestic and global are many times larger than they were six decades ago. And yet, this business has almost never not been a pitfall for investors. Why? Bad economics, for one, and two, the growth that was supposed to develop did just that, but it was already priced into the companies' stocks.
Looking for comparable examples today? Sirius Satellite Radio (Nasdaq: SIRI ) is growing, and, given its government-sanctioned duopoly with XM Satellite Radio (Nasdaq: XMSR ) , it has what would best be described as a gigantic moat filled with crocodiles, snapping turtles, pestilence, and foul odor. Unless the FCC grants more satellite radio licenses, no one is getting across that bridge into Sirius' keep. What's more, people love satellite radio. There's growth and defense. What more could an investor want?
I suggest that every bit of that growth is priced into the stock right now. The folks in charge are going to have to do something superhuman to generate value over and above expectations. Will they succeed? The possibility certainly exists. But even if Sirius just grows at a high rate, it has to exceed what is already build in to current expectations -- expectations that are obvious to anyone spending more than a few seconds thinking about the company.
So, this means that we need to focus on the smaller things, right? Value isn't apparent on the surface, so it must be deep down.
Yeah, that's a little too much, sparky
Imagine this conversation at Creampuff Inc.:
John Trahan: (answering phone) Cataloging Department, John speaking.
Shareholder: Yes, is this John Trahan?
John Trahan: Yeah, that's why my speaking parts start with "John Trahan."
Shareholder: Oh. I can't see the text over the phone.
John Trahan: May I help you with something?
Shareholder: Yes, right. The name is Kobayashi. I'm a shareholder at Creampuff.
John Trahan: Funny, you don't sound Chinese.
Shareholder: You mean I don't sound Japanese.
John Trahan: What I meant was --
Shareholder: Yeah, look, I was born in Sacramento. The reason for my call is to talk about your job performance.
John Trahan: My what?
Shareholder: Your job. Look, you've been there six months. And these TPS reports that management sent me for you are quite poor. You're really going to have to quit spending so much time playing Minesweeper instead of doing your job.
John Trahan: Who are you again?
Shareholder: I told you. Kobayashi. I'm "not Chinese," remember?
John Trahan: No. Who are you in relation to me? Why are you calling me?
Shareholder: I'm calling you because I'm your boss. I own the company you work for in my 401(k) plan, and I'm not very happy with the way things have gone. Turns out your department is dragging down the whole company, and according to this, within your department you are the second least productive employee.
John Trahan: Now wait. You're not my boss. I'm going to have to talk to --
Shareholder: Jim Abruzezze? Don't bother. I fired him.
John Trahan: You WHAT?!?
Shareholder: Only one less productive than you. I thought it would send a message.
OK, you get the point. This conversation would never happen, for a number of reasons. First and foremost, structurally, shareholders are actually not entitled to any and all information they wish to see about the operations of companies they hold. Trahan needn't worry that his TPS report is going to show up on the Yahoo! discussion boards. If the rules were different, a rival company could just buy shares in a pharmaceutical company and then demand to see in complete detail what projects it was working on. This is why boards of directors exist -- to ensure that the owners of a company are being well-served by management.
But there's something else about this conversation that is absurd. It's the thought that a shareholder would possibly know information about a company in this level of detail. It's impossible. And this leads to something that investors should probably face:
Even for companies that you study with lavish devotion, you are clueless as to 99.9% of the goings on. You're forming investing opinions and putting your capital behind them based on a tiny fraction of the known data about any one company. This is not a ratio that increases in conjunction with the number of companies you own, either.
If you're buying stocks, you're doing so each time on the thinnest hint of evidence of what's really going on at the company.
Does that make you nervous?
Well, don't be, because almost all of the information you don't know is stuff that doesn't really help you analyze the company in the first place. All information is not created equal. You don't need to know most of the stuff that is going on. You do need to know the most important things, however. So, the important is known and the unimportant is unknowable. Focusing on either of these is not the path to riches in investing. This may seem like an impasse, but it's not because there's a whole lot of space in between things "everyone knows" and things "no one cares about."
Hidden, yet important
That's the stuff of investing: finding the stuff that is important, yet not fully appreciated. Or, if you're looking to sell shares or short them: that which is important and overappreciated.
I'll give you an example, from my research at Motley Fool Hidden Gems. I noted that online gambling software company CryptoLogic (Nasdaq: CRYP ) suffered from anemic earnings growth at a time when online gambling (and especially online poker) was skyrocketing. This "obvious" point would suggest that CryptoLogic was suffering from competition, regulation, incompetence, whatever.
And yet .
The not-so-obvious facts, found not in the numbers, nor in the company's description of itself, told me that this stock had "winner" written all over it. You see, CryptoLogic had actively reduced its number of client sites by nearly half -- it wanted to focus on high-profit, high-quality online casinos that operated in highly regulated markets. Further, with a legislative ban on online gaming in the United States looming (seemingly eternally so), CryptoLogic had made the active choice to focus its marketing away from the U.S., even though the lion's share of the end market is here. The cost for growth over the short term was, of course, severe. The long-term benefit of going this route -- not having to sweat the whims of the U.S. Congress or the reputational and financial damage of having to explain a relationship with a crooked poker site -- should be substantial.
Thus far, this particular bet has paid off hugely for Hidden Gems subscribers. I found it by focusing on the middle ground: stuff that investors don't necessarily know about, but really, really should.
There's a long history among the great investors of doing this very thing. You Can Be a Stock Market Genius author and hedge fund manager Joel Greenblatt has turned each dollar invested in his firm into more than $50 (probably much more by now) by simply focusing on important things that weren't readily apparent. He made a killing by figuring out that Host Marriott (NYSE: HMT ) had all sorts of hidden value when it was spun off by Marriott International (NYSE: MAR ) , and he did so simply by reading public filings and then thinking very hard about whether the market was valuing Host properly.
How did that work out? Well. Very, very well.
Got it in you?
The moral of the story is this: The sweet spot in investing is determining what is important versus what is not, and then determining whether these important things are valued properly. Anyone can do it. Few do.
This very sweet spot is our passion at Hidden Gems, where I've had the honor of writing the last few months. For a limited time, if you subscribe to Hidden Gems, my compadre Tom Gardner will send you a copy of The Motley Fool's just-released Blue-Chip Report: 10 Monster Stocks for the Next Decade as a free gift. Click here to learn more.