Information Overload and the Law of Diminishing Returns

Information Overload and the Law of Diminishing Returns

There is a book out there called, “The Investment Checklist” by Michael Shearn. It’s loaded with good information and makes an excellent reference book for investing in the stock market but the basic premise of the book I think is very flawed. The author  literally has 57 items on his checklist he expects the investor to investigate and once you read what’s involved in some of the elements on the list, investigation turns out to be the right word. I don’t view this as being very practical or useful. Peter Lynch once wrote years ago, “the investor should be able to explain his investment idea with a crayon”.

Imagine going through all of Shearn’s 57 items of research only to find out down the road that randomness (pure chance) makes the company a bad investment anyway. Don’t under estimate randomness to have an impact on the performance of your investments.  And if you hold 10 companies in your portfolio, you would have to do all that analysis for each holding. Ridiculous really, count me out. This is an example of extreme left brain thinking. Accumulate as many facts as you can and you will make better investments. Well maybe sometimes and maybe not. There will reach a point in time where additional facts will add very little to your investment thesis and may actually cloud the picture.What we seek as investors is utility of information (the quality or property of being useful) . Once we reach the point of maximum utility of the information that we're basing our investment thesis on we should go no further in our analysis. From that point on the experience you have accumulated in your investing life will be combined with the facts you have unearthed about the company and your right brain will take over and synthesis the information. You get a "feeling" about this stock.

I wonder if the reader is suffering from information overload right now while reading this. Maybe we both are already suffering from the law of diminishing returns...Just kidding...I think...but you get the idea.

Risk Management

Risk Management

Suppose you bought  just one stock and put in your investment portfolio and held it for six months. Randomness (the role of luck) would play a huge role in the outcome of your investment. But if we apply a little risk management we can help mitigate our risk. We could buy three different stocks and hold them for a year. By increasing the number of stocks in our portfolio we have decreased the role of randomness in our investment outcome. And the longer holding period will further weaken the role randomness will play in our investments. The more stocks you add and the longer you hold them will further reduce your risk but it will reach a point of diminishing returns where you will be holding too many stocks and it will reach the point where it will reduce the return on your investments. So you have to find that balance between the two extremes. For me in my world I find holding 15 to 20 stocks pretty well manages the risk of being in the market, and the longer you hold them (time diversification) another type of risk can be eliminated as well. The number of stocks you hold in your investment portfolio will be a product of your experience and your approach to investing so there is no magic number. It might be 8 for a person who does a lot of his own research and has the courage of his own convictions. It's more a matter of your risk tolerance and taste. In the end as in all things experience will be your guide.

In the beginning managing your risk will be very much an objective (left brain) activity but after you have the experience of being in the market a few years you will develop more of a subjective approach (right brain). Like the tennis pro who can place a shot just inside a corner, you will develop a certain “touch” and know when to over weigh a holding here and under weigh another over there, when to trim a little from this position and put a little cash aside. Like a chess master you will have a “feel” for where to put your pieces and when to do it.

Separating your Ego from the Investment Process

Separating your Ego from the Investment Process


The best way to learn something is to teach it

somebody

Avoid forecasting and making predictions. When you make a prediction about the future, part of your Ego is attached to it. You want to keep your Ego out of the investing process. You really do. The Ego will get in the way of what you trying to accomplish because it will have its own agenda which involves thumbing its nose to the rest of the world when its right and making you feel frustrated and angry when it’s wrong. It has no redeeming qualities; that’s what makes it the Ego. Ever have an argument with someone who proved you wrong but you couldn’t admit it, welcome to the Ego. The Ego is all emotion with little logic and very insecure. It has to feel it is in control so it can exist. It’s really a pain in the ass but despite everything I have said about it, it is allowing me to type these words on my keyboard. So as much as I hate to admit it, I need it or I wouldn’t be able to exist as a free and separate entity. So no matter what I can do I will never really be free from the Ego. It’s like a wild horse who will never be saddled but you have to make peace with it and be aware of its impact on your investing portfolio.

Imagine watching yourself from a third person point of view, like watching a movie of yourself while you go about your business. Learn to observe your own behavior and try to stand apart from yourself and whatever you are doing. You may not be able to totally tame and control the Ego but maybe you can put a lot of furniture in his way so he doesn’t break anything or do too much damage. Making predictions about anything removes that furniture.

Dividend Growth Investing

Dividend Growth Investing

In my own investment portfolio I have about half of my money in the small to mid cap sector with a focus on growth stocks. The other half of my funds are in dividend growth like vehicles which tend to grow their dividend payout over time. The stocks in this part of my portfolio tend to be a little bigger but most of them still fall in the mid cap space.  The dividend growth part of my portfolio provides stability to offset the volatility of the smaller growth stocks I’m holding.

Dividend growth investing offers certain rewards but does require great patience as time is the critical factor needed for implementing the strategy. Dividend growth investing is based on the concept, ‘yield on cost’. I’ll give you an example from my own holdings. I bought the limited partnership, Brookfield Infrastructure Fund back in the summer of 2010. Being a limited partnership they pay you in distributions rather then dividends due to the structure of being a Master Limited Partnership. The payout that summer was $1.40 per share. Since I bought this Brookfield holding they have raised the distribution repeatedly. Presently I am receiving $2.28 per share on my holdings, so my yield on cost is 10.23. Yield on cost is the return you are getting on the book value of your original investment. In a world of low and even negative interest rates, it is very re-assuring to hold an investment that is yielding 10.23 on my original cost and this isn’t even considering the capital gains I have realized from the appreciation of the underlying stock.

Some thoughts to bear in mind when a company constantly raises their dividend over time…

An instrument that produces income is valued based on the amount of income it produces and if it produces more income, it is worth more, so not only do you benefit from a rising income stream but the value of the underlying equity will increase over time as well.

The management of a company has to allocate capital to expand the business, and invest in research and development so if on top of that they still have the money and the confidence to pay their shareholders a rising dividend over time, its telling you something good about the future of the business.

Management are shareholder orientated in that they are returning money to their investors.

As the dividends are paid out from the earnings of a company those earnings must be legitimate and not doctored up in any way.

As a general investing strategy this is hard to beat and is as good as any and probably better than most but it does take patience and discipline. You really have to buy into the strategy hook line and sinker. And you have to believe in the companies you are investing in over the long haul. To invest in this strategy you will certainly have to extend your time frames and holding periods but that’s probably good advice anyway due to the short term emphasis people put on the stock market. Wager value again.

Douglas Kee is one fund manager who appears on BNN’s Market Call talk show at times. He specializes in this area of investing and is worth listening too.

A great book on this approach to investing would be The Single Best Investment by Lowell Miller.

 

 

Stock Selection

Stock Selection

I gravitate to the Mid and Small cap sector as I find it a more inefficient area of the market where you’re more liable to come across stocks that trade at a discount to their intrinsic value. I also prefer companies that are growing revenues, cash flows and earnings. Make sure the company has a reasonable amount of debt.  I like to see the people who run the company (CEO, CFO, Directors) own a good portion of their own stock, if the CEO is also the founder of the company, even better. In Canada where I invest, small to mid cap company size would be anywhere from 100 million to 2 or 3 billion dollar market cap. In the states these numbers would be larger as it is a much bigger market.

I have some scans setup in my TD Waterhouse account where I sometimes find some interesting ideas but most of the time I steal my ideas from the professionals. I listen to Market Call on BNN (Canada’s version of CNBC) which is a phone in show featuring fund managers in Canada. Some of them are quite good while others are not so hot. Since I have a preference for the Mid and Small Cap sector I have found the following guests very good at providing me with information and stock ideas.

Stephen Takacsy
Michael Smedley
Jason Donville
Peter Hodson
Jerome Hass
Peter Imhof

Andy Nasr is good if you like dividend paying stocks while Norman Levine does a good job in the larger cap area. And John Zechner is an old hand who is worth listening too as well. And they are going to be wrong sometimes. Don't get hung up on that. Even the best stock pickers can be wrong 33 percent of the time. This isn't a game for perfectionists. And by the way this isn't meant to be the last word on who to listen to on Market Call. Everybody has different tastes and preferences. Listen to the show for awhile and decide for yourself who you would prefer to listen to.

A lot of people get hung up on the top picks of these analysts but I think it’s more important to focus on some enlightening piece of information or thought process about a particular stock they discuss on the show. Their top picks can be random as they are all on the show several times a year. Focus on all their buy recommendations and especially on why they like them.

I also borrow ideas from fund managers who report their holdings on www.sedar.com.

One thing to keep in mind, don’t just steal ideas from anybody. You want to focus on mutual fund managers that have less than 300 million dollars of assets under management. It’s important to stay small if you want to outperform the market in the mutual fund world. You also want to follow someone who runs a concentrated portfolio and who has a low portfolio turnover in his fund. Be sure to read about the mandate of the fund so you will be familiar with the investing philosophy of the fund manager. Take time to read about what the fund manager has to say about his holdings as sometimes you can stumble on some interesting piece of hidden information.The downside of doing all this is when a stock you own plunges in price. Because you took the idea from somebody else you may not have the courage of your convictions to hold your position. Therefore it would be a good idea to learn something about the stocks your holding to learn further insight. Knowledge is power. I may even do this myself.

Apart from this, one thing I have learned from hard experience is to buy cheap. That often means buying something that sold off, because they missed their quarterly numbers. If their return on invested capital (ROIC) has been good over the years it can indicate a good quality company that has gone on sale.

The market is filled with people who grew up in the eighties on the instant gratification of video games. They have no patience. If you can extend your time frames and holding periods to three years or more you can often take advantage of this market inefficiency.

A great site to visit for analyzing companies is this one from Morningstar...

http://quote.morningstar.ca/quicktakes/Stock/s_ca.aspx?t=TIH&culture=en-CA&region=CAN 

You can get most of your research done there. You can also input a companies metrics into a spreadsheet and track them yourself. I've done this and use TD Waterhouse to get the inputs I need from the financial statements they provide on their website.

Remember this is how I do it, in time everybody develops their own style and approach, once your information base expands to a certain point you may want to start using your intuitive side more (right side of your brain) as it can work in lockstep with what you already have learned about the markets so far.

One more thing don’t get hung up on the precision of the numbers, they are only there to put you in the ballpark. Remember they are based on a lot estimates and assumptions on the Income Statement and the Balance Sheet.  The numbers should be your servant not your master. Following the trend in metrics like operating income, operating margin, operating cash flow, book value per share and return on invested capital can tell you a lot about the growth prospects of a company.

And I know it’s a lot to ask but don’t be afraid to go to Sedar and look up an annual report of a company your interested in even if it is to only read management’s discussion about their companies business prospects. Hey, maybe I should do that too.

If you would like to learn how to read financial statements a good introductory book would be

Warren Buffett and the Interpretation of Financial Statements by Mary Buffett

My personal favorite in this area is

The Guide to Understanding Financial statements by S.B. Costales and Geza Szurovy

After that you might also want to try

The Five Rules for Successful Stock Investing by Pat Dorsey

Take your time and enjoy the journey. Learning how to invest in the Stock Market should be an empowering experience.

Psychology

Psychology

I have seen the enemy and it is us.

Pogo

Your own internal thought processes and feelings are probably more important than everything else put together. If you do not have your head squared away the way it should be everything else you know about the market will not help you. Therefore it pays to examine your own behavior and feelings both about yourself and the outside world in general. We are a product of our early childhood conditioning which provides us the foundation in which we judge all the experiences we have gone through since. Examine your reactions to various life situations and you will find out a lot about yourself that you might not have thought about before. Think about when someone says your wrong about something, or when the stock you just bought drops 20 percent in one day. That last one happened to me except that it happened in 20 minutes. You get the idea. The way we react to what we face in life and in the market will go along way in determining your success or failure in whatever you decide to do.

Here’s one suggestion. Try not to get too excited when things are going well and avoid getting too depressed when things turn against you. Try to keep things in balance and keep a level head. Imagine yourself on the outside of your life, looking in. Be objective and pause. Take a deep breath and breathe out. Do it again. Gain some perspective on things. Review what you have done in the market and be objective with yourself. Have you made any mistakes? If so don’t beat yourself up about it, try to correct them. Try to learn from them. It’s only a game. If on the other hand you’re doing quite well, stay humble and be thankful. The Gods of Investing and Trading must be soothed and appeased. The market is a mirror to your own internal life processes and will reflect back to you what you are telling yourself.

I’m not trying to sound like the book of knowledge here. Remember this is a diary to myself you are looking into. I’m talking to myself as much as anyone else. One other thing, sometimes there is nothing to learn. Sometimes something bad happens due to bad luck, just a random event. That’s the nature of the markets. Remember in the long run the random events both good and bad will even themselves out. It really is just a game.

We are at the Post

 We are at the Post

Investing in the stock market involves using both sides of your brain, the left (reasoning logical side) and the right (intuitive feeling side). As your knowledge base expands your feeling intuitive side will play a much bigger role in your investment decisions. My advice after being in the market a number of years is do not rush and try to learn everything at once. Take your time and learn it bit by bit and enjoy the journey. Investing in the market will offer you many rewards but it will test you at the same time. It will shine a light on your character weaknesses and expose them to the light of day. I think this is all part of the learning process we all must go through.

As I believe we create our own reality, whatever happens in our lives and in our investing is a reflection of what is going on inside of us. A person who is willing to examine himself and his own behavior will do better in the market and maybe in his life as well. If we do create our own reality as I believe, our thoughts and feelings are the tools we use to carve out our existence as we know it. Since the Stock Market is the sum total of all of its participants it is the result of everyone’s consciousness. This would make it an ideal barometer of raw emotion and feeling. You can see this in the market as Fear and Greed as the market swings wildly from one extreme to the other. As it moves through these extremes it presents the self-aware investor with opportunities to make good long term investments at attractive prices.

It’s been my experience so far that investing in the Stock Market involves

1)      Psychology  (what’s going on inside your own head)

2)      Current Market Environment  (what's going on inside the market's head)

3)      Stock Selection

4)      Portfolio Management

I’ll discuss these topics in future posts. The market is essentially a discounting mechanism, it represents the sum total of everybody’s information (left brain) and feelings and emotion (right brain). At times of extreme market behavior (fear and greed, oversold, overbought) it pays to be contrary and do the opposite of what everybody else is doing. Sort of what George did in the old Seinfeld series (my favorite episode by the way).

I guess that’s all for now. I decided to write this blog as sort of a diary to myself. Maybe somebody out there in cyberspace will benefit from it as well.