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The stock market is similar to a game of online poker. Scenarios and probabilities are continually evolving. Opponents are anonymous. Some are suckers, while some are sharks. And it’s easy to lose a lot of money if you’re not very good.
To help you avoid being one of the suckers in this game we call the stock market, here are a few things I’ve learned.
Changing expectations drive stock prices
Changes in earnings expectations are what drive stock prices. If expectations don’t change, a stock’s price won’t change much, either, even if it appears undervalued. This is a “value trap”. If analyst earnings estimates are being ratcheted downward, a stock won’t move up even if all the analysts have a “buy” rating on it and the valuation looks good. This is true for an individual stock, as well as for the stock market as a whole. When estimates are being lowered en masse, the market will fall and valuation doesn’t matter.
To avoid value traps, you need to identify companies where estimates are going to rise, while avoiding those whose estimates are being revised downward.
People dislike making their own decisions
Stocks with no analyst or media coverage are often inefficiently priced. Very few people feel comfortable doing their own analysis and making a buy or sell decision without guidance from an analyst. This is true even though the evidence suggests that mindlessly following analyst recommendations doesn’t result in above-average performance. When I find a great little company that has no analyst coverage, I’m excited because often it will be mispriced. It takes more work to understand the company because I have to start from scratch, but it’s worth the effort.
The best stocks often don’t show up in screens
Thousands of investors screen computer databases to identify cheap stocks based on things like low valuation ratios and high growth rates, low debt-to-equity levels, etc. But stocks that don’t show up in these screens can be much more interesting because they haven’t been picked over by the investment community. Yes, these gems are difficult to find; you have to look under a lot of rocks. Stocks that won’t show up in most screens include money-losing companies on the cusp of profitability; companies with “hidden” assets such as real estate or a tax-loss carryforward; companies at the beginning of a major turnround; and companies with a stellar management team in an unpopular industry.
You can learn to be a good investor, but not a great one
The way I see it, there are at least five traits super-investors such as Warren Buffett, Bill Miller, and Bruce Berkowitz share:
1. They have the ability to buy stocks while others are panicking and sell stocks while others are euphoric. This goes against our evolutionary fight-or-flight response of staying within the pack for protection and goes against the social norm of conformity.
2. Great investors are obsessive about playing the game and wanting to win. How can you teach this? A person is either driven and obsessive, or not.
3. Great investors are lucky enough to have an above-average IQ. (My IQ isn’t high enough to figure out whether a genius IQ is required, or just an above-average one.)
4. They have confidence in their own opinions without tunnel vision or arrogance.
5. They don’t require instant gratification to achieve happiness. This is becoming rarer in our fast-food, internet, FedEx society where waiting for results can seem torturous.
I would argue that none of these traits can be taught once a person reaches adulthood. By the time you are 10 or 12 years old, your potential to be an outstanding investor later in life has already been determined.
The writer is a former equities strategist at Morningstar who manages a hedge fund, Sellers Capital, in Chicago. firstname.lastname@example.org