Here we go again. Just last week, I heard about a brilliant mathematician applying his Ivy League education to developing -- what else? -- a complex set of algorithms to predict winning stocks in the market.
I wish I had a dollar for every time I've heard of someone attempting this over the years. I wouldn't have to work a regular job. I even recall my days back in college, when a very reputable Ph.D. professor talked about applying Kalman filters -- complex math that may be used to predict random events, among other things -- to anticipate stock swings.
The fact that all these folks still have their day job tells me these attempts have all failed. It also demonstrates a very important point -- numbers alone cannot capture the whole story behind winning stocks.
Running the numbers
It stands to reason that if all investing was about was running a bunch of numbers, IBM's Deep Blue would be resurrected and put to work at calculating the absolute best investment to pile into. Whoever had the biggest computer would be filthy rich, spotting winning stocks before everyone else and leaving those without a calculator at the bottom of the heap. Obviously, other factors weigh heavily in selecting successful investments.
This is not to say that numerical analysis should be eschewed, however -- it is an important tool to investors. At Motley Fool Hidden Gems, we mostly focus on quantitative measures. We like rising margins, accelerating sales, tenured leadership, a super-strong balance sheet, an attractive valuation, healthy cash flows, and a host of other quantitative measures. We will continue to spend 75% of our time in Hidden Gems on that which can be counted, compared, and tracked.
But that leaves 25% open for the squishy side of investing where we let subjectivity rule. With this time, we ask ourselves questions like: Does the company have a competitive advantage? Does the CEO seem honestly committed to outside shareholders? Do we like the product or service?
If we don't get warm fuzzy feelings or our nose starts getting twitchy with the answers to these subjective evaluations, even convincing numbers won't move us to buy. This is because we want clear confidence that what's behind the strong numbers will continue into the future.
Quality vs. quantity
It is through subjectivity that we have not, for example, owned shares of McClatchy (NYSE:MNI) and will not be buying -- even now that it has lately become a small-cap stock. Shares have fallen from $67 to $42 this past year, but we ain't buying. We simply don't -- subjectively -- think that people younger than 30 are going to subscribe to newspapers. What's worse, the newspapers, with their huge infrastructural investments, will have a very difficult time transforming themselves into successful information providers on the Internet. They are losing ground rapidly to Google (NASDAQ:GOOG), Yahoo! (NASDAQ:YHOO), and hundreds of other Internet companies, whilst they fiddle around buying and selling what were once local monopolies.
Another area of the market we have avoided is movie theaters. Once again, the emerging generation of consumers is less interested in going out to the movies and more interested in what they can get on demand. Content now comes in several new ways -- a huge library of movies available through a subscription to Netflix (NASDAQ:NFLX), cable television, or even video podcasts downloaded to iPods. In the near future, newly released movies and interactive content will even come directly to an Internet-enabled flat screen, via services offered through traditional phone companies such as AT&T (NYSE:T).
So we shy away from buying a stock like Carmike Cinemas (NASDAQ:CKEC). It has been run well financially, but sales and earnings growth are drying up rapidly as it works harder to lure consumers to theaters. Harman International (NYSE:HAR) is an example of a company on the opposite side of this trend, seeing increasing sales of audio and video equipment to homeowners building their own theaters.
Everything is relative
So don't focus solely on the mathematics of investing -- look beyond the numbers to understand more subjective drivers of success in a business. In fact, the measurable stats that we scrutinize every day -- cash flow, profit margins, and the like -- are actually derived from qualitative successes in company operations, so they are important to identify. Tilt toward buying into trends that will gain in relevance over the next five to 10 years, as opposed to those being threatened with extinction.
At our Hidden Gems small-cap service, we look at dozens of companies that are gradually losing relevance because it points us to the competition that is gaining relevance. To see all of the industries and trends we're tracking now, and the most promising stocks we recommend for the next decade, join us at Hidden Gems free for 30 days.
Fool contributor Dave Mock thinks stories that include only numbers are pretty boring. Stories with ABCs are much more exciting. He owns no shares in companies mentioned in this article. The longtime Fool is also the author of The Qualcomm Equation . Netflix is a current Stock Advisor recommendation; AT&T is a former one. The Motley Fool has adisclosure policy.
