If you read as much market commentary as some of us, you are confronted with a lot of "analysis" about where the "smart money" is moving at any given point in time -- even today. Assuming we buy into the applicability of currency to be located at various points along the intellectual spectrum, let's consider what the not-so-smart money, or what (in less politically correct times) might even be referred to as the "dumb money," might be doing:
1. Following Wall Street analyst recommendations.
The Nov. 27, 2006, issue of Barron's quotes one of the creators of the Charles Schwab Equity Rating System as saying, "Dumb money historically has been the [Wall Street] analysts' recommendations." I think most experienced investors would agree with that.
Although there have been some significant reforms made recently to the practices of Wall Street analysts -- they now must actually declare in their written recommendations that they believe what they have written, something that was not required until quite recently -- there are still some significant conflicts of interest. Moreover, there is no reason whatsoever to believe that analyst reports as a whole are meant to help individual investors make money.
2. Buying managed mutual funds recommended by brokers and other financial advisors.
As I've written before, a recent study demonstrates that individuals pick better mutual funds than brokers do, and those same individuals realize returns about three percentage points higher (after costs) than broker-sold funds. People buying funds recommended by brokers aren't dumb, they just haven't seen the facts. (And their brokers aren't likely to share the facts with them.)
3. Adhering to any strategy that involves moving money in response to news that's already out -- especially news that just came out.
As they say, if it's in the news, it's in the price -- and recent news changes the price more than the intrinsic value.
So where is the smart money moving?
The smart money today, as with every other day, is moving with a breathtaking lack of measurable speed (or noticeable market-moving effect) into investments that have been carefully studied for a good deal of time. These are companies selected not on the basis of headline fodder, interest rate speculation, or a single new data point released by the Federal Reserve Board.
Instead, they are companies that have:
- High returns on equity and capital, demonstrating management effectiveness.
- Long-term growth opportunities.
- Defensible "moats" that will protect the profit margins the superior company enjoys and oftentimes prevent potential adversaries from even trying to compete.
- An attractive current price in relation to the long-term cash flows the business will produce.
It doesn't need to be much more complicated than that, though certainly assessing what all the future cash flows of a business will be is not a task that is simple -- or even possible -- to correctly predict with precision.
Finally, pay particular attention, as Warren Buffett does, to the defensibility of a company's competitive advantage. Study the reasons why -- such as patents, strong brands, or network effects -- companies like Disney
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This article was first published on Feb. 9, 2007. It has been updated.