Blessed by the Potato

Aside: I’m not 100% happy with this draft, and as you can see by the page number I’ve been sitting on it for a while. I was hoping MG would put it up as a Potato Wedges column at themoneygardener — perhaps with some suggestions for edits — but I sent it to him last Friday and haven’t heard anything back all week… Now TMW has a long interview up (with more to come) with Nurse Brad and Preet on analyst research, so the time seemed right!

There are a lot of important tools to tap when investing, especially if you’re going to go about trying to pick individual companies to invest in.

Of course, any discussion about picking individual stocks should start with a reference to efficient market theory, the idea that one can’t outperform the market as a whole with any certainty or consistency, so the best option is just to buy the index and relax. I personally don’t believe in efficient market theory: it’s pretty obvious that the market is not efficient. It’s emotional, with wild swings and overshoots in both directions, and corrections to news events — while quick — are not instantaneous. Plus the record of investors like Warren Buffet are too good to be due to chance alone, so they must be somehow outsmarting the market. However, while the markets may be inefficient in a theoretical sense, that does not mean that you could outperform the market. Indeed, I’ve been trying this, and it has lead to nothing but fail.

Nevertheless, if you think you’ve got what it takes to outperform and are going to try your hand at stockpicking, then you’re going to need a dartboard.

…Research! I meant you’re going to have to do some research! Not throw darts, that’d just be silly. You can go about your research in any fashion that you see fit — it’s your money, and I’m not particularly talented or qualified to be handing out advice in this area. That’s not going to stop me from writing about it, but faithful reader, you should be aware at all times of who is giving you your information and how trustworthy it is — and my issue is that I’m still fairly new at active investing and stock research in particular. So that said, your first step is to come up with an investment idea. There are simply too many companies out there to just start researching all of them, so the criteria here can be very loose, but somehow something about a company has got to catch your attention to make you want to look into them further: maybe a mention in the news , or a featurette in a blog you read every day, or just a good consumer experience in your everyday life (which would be the Peter Lynch philosophy). Then you can start looking for resources to make a decision: the economic environment, first-hand experience, the company’s financial reports, and other resources varying from technical analysis to analyst reports.

Odds are, your broker (especially if they’re an arm of a big bank) has some analysts on staff covering the larger, more liquid companies in Canada. They may also (or only) provide access to 3rd party analyst reports, such as those from S&P or morningside. These analyst reports are great things to read for the most part since they often highlight the important numbers in the fundamentals, they give you a sanity check on your own analysis, and they can also give you a summary of the business and the key outside influences. However, the thing they are best known for, the headline buy/sell/hold (or equivalent ranking) rating is, IMHO, one of the less valuable components of the reports. I have been impressed with TD’s record when they go out on a limb to rate something an “action list buy” instead of just a buy or hold, and if I see one of those in a morning report I will often have at least a cursory glance at a company before deciding to not bother… but generally, someone who relies on those ratings alone to make their investing decisions is asking for trouble.

First off, those headline ratings sometimes seem at odds with the detailed analysis. Whether this is caused by an overall sense of bearishness/bullishness at the broker (and RBC seems to suffer from these bouts of rating everything high or everything low in a given month, in my limited experience), or other less savoury factors is unknown. Most analysts do disclose conflicts of interest, for example when their firm is doing business with the rated company, but disclosing bias is not quite the same as being unbaised. Sometimes it’s pure momentum: a stock is hot, so they rate it a buy, even if it’s already overshot the fundamentals they talk about in the fine print.

Note that no where in there did I mention personal finance bloggers. They are actually a good resource to read to get new ideas and new perspectives on things, but for the love of all that is starchy, you must resist the urge to blindly follow their advice (especially mine — go back to my archives and see just how poor my advice has been over the last year!). Of course, my pleas to not blindly follow advice is becoming something of a mantra, so I’ll leave it at that. (Aside: one should read personal finance blogs daily, even if you don’t follow the advice. And click on the advertising links. Twice.) I suppose the important theme here is: can you follow the logic?

The issue of analyst coverage has come up a fair bit lately, which is what prompted me to try to dust off this column and actually get it out. If you haven’t yet heard of the minor spat between the John Stewart show and MSNBC/Jim Cramer’s Mad Money then you should watch at the very least the relevant episode of the Daily Show. I thought that John Stewart had a very good point to make, which was that the financial news shows were not asking the hard questions, they were not digging into the stories, and they were being naive about whether executives they were interviewing were lying to them. That they, like the corporate world in general, were too focused on the short-term movements and didn’t have the interests of the long-term investor (or the stability of the economy as a whole) in mind. If you call in to listen to a conference call for a company’s quarterly results, you often will hear the real analysts asking the hard questions. Sometimes they come out of the gate with an answer in mind, as I seem to recall an RBC analyst in full bearish mode harping on the Yellow Pages management about dividend cuts, how big they’d be, and when they’d come, and if they’d cut it just because the share price was low so the yield would then look more normal, and maybe they could cut, just to give some more breathing room, and the management having to brush all this off… but the analysts should, at some point, be getting the important questions answered for you.

Stock analysis reports were also the topic of discussion recently at Canadian Dream and Four Pillars. Nurse Brad, of Triaging My Way To Financial Success fame has started to sell some of his stock analysis reports, and there was some minor debate on what to charge, and whether they would sell.

Now, I haven’t read one of these yet (I probably should have dropped him a line and bugged him for a review copy before writing this column, but that would deprive me of the ability to make two columns out of the issue), but at the suggested price of $20, I have to wonder how worthwhile they’ll be. Don’t get me wrong, they sound like fantastic learning tools, and I’ve been very impressed by the depth of Brad’s research in the past, in particular his on-site visit to a brewery to uncover inefficiencies. It sounds like you’ll get plenty of content and research to show for your money. However, for a small-time investor like myself, a $20 fee can represent something like 1% of a position in a stock, so to be worthwhile this research would have to improve my returns by at least 1% just to break even*. And of course most analysts’ research comes to a “hold” conclusion — that a given stock doesn’t look like it will drastically over- or under-perform the market as a whole. That’s probably true for most companies, perhaps axiomatically, but that doesn’t make you feel any better if you shelled out $20 for “meh”.

* – that’s not quite true, since I could amortize the cost of the report over a few years, in which case I might only need say a quarter of a percent (per year) outperformance to make the research worthwhile; on the other hand if the data became stale in less than a year, then the improvement would have to be better.

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