Nine Lessons in Speculation

With courtesy from The Big Picture

John Dorfman has been an asset manager for decades and a columnist for Bloomberg since 1997. For his final Bloomberg column, he highlights nine lessons that emerged from writing that column. (My own comments are italicized): Here is an overview of these nine lessons:

Lesson One: Out-of-favor stocks are the best road to capital gains.

Stocks with extremely low price-earnings ratios should heighten your resolve to go against the crowd and buy stocks that are unpopular. In eight years from 1999 through 2006, investing in these low P/E outliers produced a hypothetical gain of 830 percent, while the S&P 500 was up 31 percent.

Nevertheless, P/E ratios guide one toward a measure of fair value only once the issue is upheld by credentials in the fundamental nature of the business.

Two: Errant Analysts: Don’t be swayed by what Wall Street analysts say.

From 1998 through 2006 Dorfman tracked the annual performance of the four stocks analysts most loved (those with unanimous “buy” recommendations for a large number of analysts) and the four they most hated (those with a high percentage of “sell” recommendations).

Over the nine years from 1998 through 2006, the stocks the analysts loved posted an average annual loss of 3.7 percent. The despised stocks did better, down 0.2 percent annually. Neither group beat the overall market.

Especially for the small investor, heed or attention should never be paid at all. The Street was never intended for the well being of the individual investor and it never will be.

Three: High portfolio turnover is not necessary for good results.

Over trading, selling too soon, excess commissions, transaction costs and taxes — all hurt performance.

It is not so much the loss of capital but rather the eventual profits compounded many times over that are lost with such transactions.

Four: Meaningless Momentum

The investment value of a stock is independent of whether it has been moving up or down. That matters to Traders, but it should be of little consequence to Investors.

This is because Traders are looking to take their profits and seek for another trade of better return. Investors on the other hand initially search for companies they wish to own forever; thereby eliminating any concern for prices or momentum once they have made their purchase.

Five: Mission Impossible Predicting the market with consistency is extremely difficult.

I’ve learned to take all market predictions, including my own, with a grain of salt. In my very first column for Bloomberg News, in October 1997, I predicted that the bull market of 1991-1997 would end in 1998. It didn’t end until 2000. On the plus side, I correctly forecast that market declines in 2004 and 2006 wouldn’t turn into bear markets. (We noted a very similar issue in the Folly of Forecasting).

It wasn’t only Bloomberg, but even good ol’ Alan Greenspan was warning in 1997 that the markets had reached a dangerous level of speculation. Surprisingly, or maybe not surprising for some, most of the gains produced from stocks, especially the NASDAQ came over the next 3 years. Just another proof that Markets can and many times will remain irrationally exuberant, much longer than you can stay solvent”.

Six: Predicting the economy is probably even harder.

For seven years, Dorfman ran an economic prediction contest, in which participants were asked to forecast variables such as growth in U.S. gross domestic product, oil prices, and unemployment. Few people did well, and among those who did, there were few repeats from one year to the next.

I may add that one of the reasons for these erroneous predictions is due to the fact that as the information does set in that say the economy is due for a recession, a level of worry slowly arises, placing the economy in the nature of a halt, with many expecting to see a movement in line with their speculations. This sluggish time frame invites conception that the worse is behind us, or better, may never come. The growth and consumption continues.

Seven: High valuations alone aren’t a good reason to sell a stock short.

A short sale is in essence a bet that a stock will decline. Dorfman’s efforts to select shorts based on high price-earnings or price-book ratios were mostly unsuccessful.

As all good short sellers should know, just because a stock is expensive does not mean it won’t get more expensive. Similarly, any value player should know that merely because a stock is cheap is no guarantee that it won’t get even cheaper.

This falls in line with Number 1 – Buying on Low Valuations. By contrast high valuations, such as those seen in the late bull runs, may not be a substantial reason to sell. This is obviously dependent solely on the nature of the owner of the security.

A mere speculator that sees an overvalued market or a sluggish future outlook may wish to take his profits and seek better returns elsewhere or just a better buying opportunity at a later time. An Investor though may find that his time and effort in finding the issue was worth it and that he is willing to take a decline and save on taxes, fees, commissions, etc.

Eight: High profits alone are no reason to invest in a stock.

Dorfman found that over a seven year period (August 1998 through August 2005) a list of the 15 companies he considered “most profitable” performed almost identically with the overall stock market. Problem was it was only after considerable research and much higher transaction costs. The SPY would have been a better play.

Nine: Dialog with readers was one of the best parts of my experience as a columnist.

I think all columnists would agree on that one!

Nine Lessons I Learned in the Past Nine Years
John Dorfman
Bloomberg, Feb. 13 2007


Tags: ,

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: