For the average person, the stock market provides the easiest vehicle to feeling like the master of the universe or the village idiot, sometimes in the same week. No investor -- not Warren Buffett, not George Soros, not Peter Lynch -- has escaped without a few embarrassing losses. And nowhere else can a regular person compete in the same arena as legends and occasionally win by picking the right stocks.
How you find the "right" stocks, though, depends a lot on that which you try to be right about. This is where the concept of unequal rights comes in to the picture. Focus on being right about the right things and you can improve your odds of investment success; focus on less important, things, though, and you may be making things even harder on yourself.
Low-priority rights
For all the talk about earnings and whether a company will meet or beat estimates, you'd think that short-term earnings performance is really important. Nuh-uh. Oh, I don't doubt that Medtronic (NYSE:MDT) will sell off if revenue comes in a bit short or that a stock like Gap (NYSE:GPS) could move dramatically in response to one quarter's earnings. But I just don't think it matters so much over the long haul: I think big-picture growth and margin improvement simply matter more than the staccato pace of quarter-by-quarter performance versus the bar set by a gaggle of analysts.
Likewise, I think forecasting short-term stock moves is a low-priority type of being right. Obviously this isn't true for traders, but then traders aren't exactly the bread-and-butter clientele for The Motley Fool, are they? I personally don't see anything inherently wrong with trading (if you're good at it), but it's just not something that average investors can, or should, try for themselves. As a result, I'm far more of the opinion that a stock picker should invest more time in finding good companies and a little less in chart voodoo to determine the precise time to buy or sell.
Medium-priority rights
Being right about a specific product can take you a ways in the market, but not always all the way. It really comes down to "what have you done for me lately?" and not all product launches are equal. The success of Vista or the new PlayStation will likely be blips on the scope for Microsoft (NASDAQ:MSFT) and Sony (NYSE:SNE) and probably not worth a tremendous amount of individual investor research.
On the flip side, if you can be right about a smaller company like Intuitive Surgical (NASDAQ:ISRG) or Hansen Natural (NASDAQ:HANS), that's a whole 'nuther kettle of fish -- when you're talking about a small company with a single product (or a singularly hot new product), all bets are off. So perhaps the lesson is just to keep a sense of perspective here: If a new product isn't going to change the company, don't worry about it so much; but if it's a product that could propel a company into the big leagues (or ruin the company outright), definitely put in the extra work.
Valuation -- not the most important
I know, I know -- how can a value guy like me say that valuation isn't important? Well, first of all, I'm not saying that valuation is unimportant -- I'm just saying that's it's not most important.
The trouble with valuation is that it's the culmination of a lot of guesswork, wrapped in a pretty little package of what looks like mathematical certainty. Maybe you think a stock with a price-to-earnings-to-growth number below 1.00 is cheap, but what if the analysts are completely off base on the growth rate? What if your carefully crafted discounted cash flow model uses a discount rate that's just ridiculous?
I'm not ashamed to admit that I missed out on Ultra Petroleum (AMEX:UPL) primarily because the valuation approach I use for energy companies doesn't work quite so well for these rare hyper-growth companies. Likewise, my valuation methodology on pawn lender First Cash Financial (NASDAQ:FCFS) may be little more than "approximately right," but it's a five-bagger and counting for me.
The Holy Grail(s)
If armchair investors make any one particular mistake more than any other, it's in underestimating the importance of both a company's management and its inherent competitive advantage (or lack thereof). And, to be fair, I can see why that would be -- I'm not sure there are many concepts less concrete or empirical.
Who knew that geeky guys like Bill Gates from Microsoft or Steve Jobs of Apple would go on to do what they did? And how could you have figured out which one would go on to change the computing world at a fundamental level?
Honestly, it's difficult. I happen to think that return on invested capital (ROIC) is a good metric for management and company evaluation, but even this number alone can't tell you if the books are being cooked or if the company's simply enjoying a cyclical spike. Instead, maybe it's worth pointing to some of the hallmarks of bad managers and extrapolating what the opposite approach might be.
In my experience, excuse-makers are seldom great managers. Every company is eventually going to face a "stuff happens" moment, but some companies seem to offer a new excuse every couple of quarters as to why results aren't up to scratch. At the bottom line, good managers produce results and bad managers produce excuses.
Anecdotally, I've also learned to be very skeptical of option-hogs. If you read a company's SEC filings, you can generally see which company managers took home the most options. If you see a huge share going to the CEO, be wary. Most of them are extremely well paid to start with, and if they're overreaching for options, you might have a bad one. Good managers share the spoils; bad managers look out for themselves at all costs.
Durable competitive advantage is no more obvious, nor less important, than the quality of the managers at the tiller. Why has Southwest (NYSE:LUV) thrived in what I believe to be one of the most abysmal industries? How have the Japanese carmakers done so well for so long? How do you know which teen-oriented retailer has the right stuff to survive its clients' fickle fashion tastes?
Alas, there aren't many any easy answers here either. Michael Porter has written worthwhile books on the subject, and metrics like ROIC can point you in the right direction, but there's no substitute for hard study and experience. Simply put, read and research as much as you can on past winners and you'll begin to get a sense of those things that really matter in various industries. Is it hard? Yup. Is it fun? Not always. But that's the price of wanting to be right about something that's really important.
Wrapping it up
Nobody is going to be right about everything. What you've got to do, then, is figure out which things are the most important to get right. For my money, I can't think of anything more important than having a clever, opportunistic, and scrupulously honest team in charge of a company whose products or services have a true leg up on the competition. After all, markets and industries change over time, and it's usually only the cream of the crop that sticks around and makes lasting money for shareholders.
When it's all said and done, I want to be very right about the quality of the management and the competitive advantage and vaguely right about the valuation of a company's stock. Paying 10% too much for a great company isn't terrible; you can make that back over time. But buying a "bargain" that is poorly run rarely works out well over the long haul.
For more right-thinking Foolishness:
You'll find Gap recommended in both Stock Advisor and Inside Value, andMicrosoft recommended inInside Value. Intuitive Surgical is aRule Breakersselection.A free trial will show you why investors like you and our advisers like these stocks.
Fool contributor Stephen Simpson owns shares of First Cash Financial, but has no financial interest in any other stocks mentioned (that means he's neither long nor short the shares). The Motley Fool has a disclosure policy.
