They're coming out now -- the "Hot Stocks for 2004!" spectaculars from every periodical that addresses the stock markets. Each one boasts a group of companies sure to benefit from certain trends in the market, the economy, or demographics. Why do publications put these things out?
Because they're big sellers every year, that's why. Of course, it would be remiss were I not to mention that The Motley Fool has it's own "best stocks for the year ahead" product, enchantingly titled Stocks 2004. But here's a difference.
Crystal ball
We fully admit to having no idea what's going to happen in the year ahead. You might consider this a weakness, but don't. Here's a little secret -- all those folks who are saying "the market will do X" don't know either. They just don't admit it. Anyone could take a look at the performance of such folks and recognize that successful short-term forecasting of stock-market returns has more to do with blind luck than anything else.
Recall that in late-1999, few pundits saw anything but clear sailing and a stock market headed to the skies. Those who did see impending doom were generally the same who had seen impending doom for years. And remember what happened once the Federal Reserve started cutting rates? How many times did you hear that the recovery would begin nine months later, since "that's how long rate cuts take to affect the economy." It didn't happen that way. Even if it had, it would have been more akin to someone winning in "Bingo," where winning doesn't imply that someone is more skilled at the game.
You see, talking heads have an enormous amount of, oh, let's call it "babble capital" tied up in being seen as having market knowledge. Just get me on TV, and spell my name right. There's an enormous amount of money to be made in making the predictions, and no one really notices if they are wrong -- the next year you just roll out more predictions. Just ask Elaine Garzarelli -- she called the 1987 stock market drop and then spent the next decade getting everything else wrong.
See the big picture
It's important that you recognize what is important and what is not. I am extremely happy that our stock picks from 2003 beat the market return by such a healthy margin. I would think that many folks would look at a 39% annual return and say, "I'll take it."
But when we compiled Stocks 2003, just as we've done for Stocks 2004, we took a certain element of what our analysts provided very seriously. We wanted to ensure that they knew the companies they selected backwards and forwards. We ensured that they spent as much time thinking of the risk side of the ledger as they had the rewards. We played a game with ourselves that I think every investor ought to. It's called "multiple-stage thinking," and I'm convinced that if more investors used it, they would avoid many of the biggest mistakes they make -- including being blind to the fact that the mistake is made when action is taken in ignorance of a risk, not when the risk makes itself known.
Using Matt Richey's pick from Stocks 2003, Quality Systems, (NASDAQ:QSII), which nearly doubled during the year, let's take the first stage of thinking. Quality Systems is a medical software company specializing, among other things, in a rapidly growing business: electronic medical records. Its earnings in this pursuit alone had increased more than 23% for the last year when Matt made his selection. No, 23% growth in the past doesn't equal 23% in the future -- folks who bought into the growth to the sky messages at Cisco (NASDAQ:CSCO), CMGI (NASDAQ:CMGI), Sun Microsystems (NASDAQ:SUNW), and a host of others learned this the hard way. Matt's next steps were to determine a series of "if-then" statements to test his selection against risk.
Someday we'll all invest this way
Very few investors do this very well. Heck, many economists do this poorly, and we know of only a precious few politicians who think in multiple stages prior to committing our money to their pet projects. And yet, from a capital allocation standpoint, I can think of nothing more important than stress-testing an idea. Multiple-stage thinking goes something like this:
Question: What happens if the market for Quality Systems' products is smaller than projected?
Answer: At $44 million in revenue, Quality Systems' market could be smaller by a factor of four, and it would still have plenty of growth potential. American regulations such as HIPAA make the chances of this quite unlikely.
Question: Couldn't HIPAA be changed and/or scrapped?
Answer: HIPAA is not the only wind at Quality Systems' back. The company's products are productivity enhancers that assist doctors. Quality Systems' software helps eliminate substantial costs for transcription services.
Question: But is it possible that transcription services prices will go down based on lower demand?
Answer: There has been a decided move in transcription activities to overseas locations in the last five years, primarily to India. It is unlikely that the transcription services have much additional room for cost savings. It is still possible.
Question: Assume everything that has a marginally probable chance of going wrong for Quality Systems does in fact go wrong. Is it still a compelling buy if revenues are flat or decline?
And so on. The answer for the last question, in every single Stocks 2003 selection, had to be "yes." And for Stocks 2004, released just this month, we made the same demand on our analysts. Given every reasonable risk you can think of coming to pass, is this stock a compelling opportunity at existing prices. Once again, in each case, the answer was "yes."
Obviously, this is a process that can end up involving weeks, if not months of research. That's what you get with each stock selection -- something that has been an obsession for the analyst for a considerable period of time. We demand it.
"Ah," but you say, "some of these selections from last year failed to beat the S&P 500! Surely, your analysts missed something!" The answer to this, once again, is "yes." No investor in the history of mankind can consider every risk or assume perfect knowledge. No matter what, there will be things you miss, or things that come as a surprise to everyone. It happened last year; it is certain to happen this year.
It's about risk and reward
One of the companies we selected last year, Alliance Capital (NYSE:AC), was implicated in the mutual fund trading scandals. The chances of an outsider ferreting out such a risk factor approaches zero. These are the realities of investing and why money put into stocks is known as "risk capital." Not all risks are equal, however, and there's a vast difference in the risks taken by putting money into a Berkshire Hathaway (NYSE:BRK.b) than a fly-by-night penny stock picked off a tout sheet.
There's one final consideration here: Just because you've discovered a bargain doesn't mean that the market will immediately take a shine to it. It's the final reason why we think that market prognostications are goofy. It can sometimes take years for a bargain to be widely recognized as such. Two companies in Stocks 2004 have engineered spectacular turnarounds unappreciated by the stock market. There's not much we (or anyone) can do about this.
We instead concern ourselves with what we can control. Our focus is on finding opportunities for investment that offer a much higher chance for better-than-average gains over the long-term than for loss of capital. By that measure, I'm pleased with the 11 investment ideas we've settled on for Stocks 2004.
Bill Mann owns shares of Berkshire Hathaway.
