A while ago, in Painfully Obvious Stock Tips, I described how beating the average performance of the market was really a simple matter of eliminating "bad" stocks and choosing from among the "good" ones that remain. Throw out the companies that perform "worse than average," and pick only from the ones that do "better than average," and voila! You're likely to earn better-than-average returns.
Today, I want to expand on that concept -- but only a little. If you're a statistics major, if your idea of an enjoyable way to spend an evening is doing calculus problems for fun, this column's probably not for you. Because I'm going to keep this really simple.
David vs. Goliath, Inc.
Let's get one thing out in the open right away. In the quest for superior, market-beating investment returns, individual investors are at an apparent disadvantage to the professionals at huge investment houses like Merrill Lynch
The good news is that you don't need all of the trappings of an investment bank to perform like one -- or better. You can get by without the interns, the expensive, proprietary data feeds, and, yes, the fortune-tellers too. Because they simply aren't necessary to beat the market. Don't believe me? Take a look at the returns we've been racking up at Motley Fool Hidden Gems over the past two years. In the 2003 bull market, in the secular bear of 2004 and 2005, we're continuing to beat the pants off the S&P 500 by a margin of, at last count, 22% average returns to 5% for similar amounts invested in the index.
And how do we do it? By focusing on what's important. By filtering out the noise. By concentrating on just a very few simple factors that help us to eliminate losing investment ideas and choose only from among the likely winners.
Trying too hard
I recently read a research report put out by one of Wall Street's premier investment houses. Nearly 20 pages in length, it crunches P/E ratios, returns on equity and on investment, calculations of market size and penetration, analyses of suppliers' pricing power, and on and on, ad nauseam. The analyst who prepared the report must have put hundreds of hours into its preparation, trying to cover every conceivable angle. But was all that effort rewarded? Did his painstaking efforts to nail down an accurate valuation of the company, 12 months in the future, pay off?
Sort of yes, but sort of no. His price target, due to arrive by early 2006, was actually hit weeks ago, just a few months after the report was published. It turned out that despite all his effort, the analyst had still vastly underestimated the company's potential.
And it works the other way as well. For example, look at some of the price targets for Cisco Systems
And where is Cisco trading at now? At $17 -- approximately 6% below the most conservative prediction and 18% below the average estimate.
So as the saying goes, "performance may vary." It seems like these analysts are going to an awful lot of effort preparing awfully detailed reports ... yet on average, their answers miss the mark by more than 15%.
The CIA on investing
So with all their resources, and with all the time they put into valuing these companies, why aren't the "professionals" producing more accurate results? A 1973 report written by analyst Richards J. Heuer at the CIA (yes, that CIA) suggests one answer. In this study, several of the people who set the odds on horse races were tested to determine whether having more information resulted in their making better predictions on race winners. Given 88 pieces of data to choose from, the handicappers, as they're called, were told to choose the five bits of information they considered most important (e.g., the horse's win/loss record, the jockey's record, the length of the race, and so on). They were then asked to place bets on a race based on their preferred data and to state how confident they were of their predictions.
In part two of the test, researchers doubled the amount of data given to the handicappers. They got their "preferred five" pieces of data, plus five more statistics that they considered of lesser importance. Bets were again placed. Confidence was remeasured. This test was repeated with 20 and then with 40 statistics to work from.
The researchers then analyzed the results and concluded that the handicappers' accuracy did not improve as they were given more and more data. In fact, several handicappers got worse the more data they were fed. But while the accuracy of their predictions didn't increase with the amount of information they had to work with, their confidence in those predictions did. This despite the fact that, by their own admission, the extra data was not as useful to them as the original "preferred five" pieces of information.
Henry David Thoreau on investing
All of which suggests that Henry David Thoreau was right. If you recall from your high school American Lit class, in Walden, Thoreau wrote:
"Simplicity, simplicity, simplicity! I say, let your affairs be as two or three, and not a hundred or a thousand; instead of a million, count half a dozen, and keep your accounts on your thumb nail. ... Simplify, simplify."
Is it a coincidence that Thoreau urged limiting our focus to "half a dozen" things at a time, and that the handicappers picked just as many winning horses with five pieces of essential data as they did with those five, plus 35 others? Perhaps. But coincidence or not, it works.
Because when you see a company selling for 100 times earnings and growing at 10% a year, you don't need a research staff to tell you it's overpriced. On the other hand, when a company sells for 10 times free cash flow, grows profits 25% per year, and is managed by seasoned, conservative management, you know that that's a company worth investigating. You need only understand a few key metrics to help you separate the winners from the losers. And if you can manage that, then yes, you can beat the averages -- and the analysts, too.
At Motley Fool Hidden Gems, we look for obvious winners like the one just described (incidentally, it's protective products maker Mine Safety Appliances, and since we bought it two years ago, it's up nearly 130%. It's just one of more than 50 promising stock ideas we've passed on to our subscribers over the past two years. If you'd like to see the rest, we're offering a one-month free trial right now. By trying out the service, you're entitled to read every recommendation we've given to date. You have nothing to lose.
This article was originally published on May 13, 2005. It has been updated.