How do you get "better" at investing?

Water Cooler Investing
#1

So this might be too abstract of a question but here goes nothing: I recently created a stock pitch from scratch with someone employed on the buyside and overall just very knowledgable when it comes to investing. It was a tremendous learning experience for me and I feel like I progressed a lot. That said being said, how do you guys approach getting better at picking stocks?

Clearly, I can’t sit down with this person everytime I have an idea. Do you have a circle of peers you bounce ideas off of? Share ideas on analyforum? Post write ups on value investors club? I’m open to hearing ideas.

#2

Those guys are a bunch of assholes.

Read up on how the greats pick stocks, then realize that everyone else is emulating their style and do something completely different. Figure out your style and dive in. Like anything else, there’s no substitute for experience. After you exit a position figure out why you got it right or wrong. Almost everyone picks apart their bad buys to try to figure out what they did wrong, but many people don’t spend time on their good calls. Figuring out why you got your call right is one of the most important things I can think of. Then you can replicate it…hopefully.

#3

It’s a difficult question, the problem with security analysis is that there is no feedback. The world’s best investor can tell you you’re wrong, and you may still be right. Furthermore, investing is looking at conflicting pieces of information and coming to a conclusion, and another person may evaluate the same information totally differently.

Two things - theory and practice. Theory - you need to read and study what other great investors are doing and try to absorb their ways of looking at investment. Practice - you need to constantly research stocks over and over again. I think you need to structure your practice in a way by first starting off studying simple stocks, and then moving on to more complicated valuations. Perhaps come up with a plan or “curriculum” of how you’re going to progress.

What I did was: I started off analyzing stable cash cow type stocks. After that I slowly moved on to tech growth firms as I feel that sector is relatively easy to understand. Eventually, I’ll probably start looking at other styles etc etc. (I need to come up with a plan as well). But this process takes years to master.

#4

I agree that lack of feedback is the most challenging aspect of learning to invest.

I would recommend that anyone interested in investing become at least intermediate in the following core areas first though:

  • Accounting

  • Valuation

  • Porter

  • Various styles of investing (value, growth, momentum)

That will give you the big picture. Once you have that in place, you can start reverse engineering successful investments to understand why they worked (you could also reverse engineer the worst performing stocks of the year as well to see why they blew up).

You have to look at hundreds of pitches before it begins to really click, so having a method for sifting through quickly is of paramount importance. Whatever approach you use, try to avoid anything that requires manual data compilation as that is a huge waste of time (you learn nothing after the first few stocks). You will be slow at first in general when looking at stocks, but it speeds up after a while.

#5

Starting with one style is a good idea as well – cash cow is pretty straight forward and a lot of people start there since it’s bumper bowling. You’re unlikely to find a lot of values in very easy to value steady eddie businesses, but it’s good for analytical practice. I recommend WDFC as a decent starting place.

That said, the real money is made during the migration between investor styles (value stocks that become growth, or preferably momentum). You get paid three ways owning stocks: dividends, earnings growth, and multiple expansion. EPS growth + multiple expansion is where the serious money is made.

Edit: buyouts are a fourth way to get paid, but I never like to invest on buyout speculation (it’s nice to have the optionality, but I’d rather own something at a good price with a catalyst then assume the company will get bought out). Most stocks could get taken at most valuations their likely to trade at, and yet, most companies do not get sold. Better to have a valid investment thesis and get lucky than speculate on a buyout and then get unlucky if it doesn’t happen and the price sags.

#6

Having a great mentor is definitely helpful. Most people won’t take the time to banter with you about investing unless they are really committed to helping you or you have some type of relationship with them wherein you exchange investment ideas on an ongoing basis. However, as you must know by now, to really go through quality analysis with a fine-tooth comb is a very time-consuming process. You get faster at it the more you learn about the industry and the more patterns you’re able to recognize.

If it were so easy to form quick AND detailed opinions, there wouldn’t be a need for investment analysts who are basically willing to scrub the financials, speak with management teams and competitors, visit stores to try to get firsthand insights, and so forth. However if there’s one thing that you may find encouraging, nine out of ten companies you look at probably will be “hold” or “pass” for the simple reason that there’s not enough margin of safety to make an outsized bet on them. So sometimes if you don’t see something compelling about a company right away, it doesn’t necessarily mean that a compelling story doesn’t exist…but in a lot of cases, it really is fairly priced in the market.

As bromion mentioned, try to find some good stock pitches to learn from and/or emulate. Value Investors Club might have some good pitches here and there, same for SeekingAlpha, but you just have to wade through a lot of sh!t before you find anything interesting…sort of like the real stock markets. Once you find something good though, definitely get to know it inside and out, and most importantly always ask WHY something is the way that it is. Your role as an analyst is to challenge everything you see anyway.

There are two people on AnalystForum that I consider suffciently competent and trustworthy in reviewing my pitches and providing advice. Perhaps there are a coule more in real life aside from the people I work with on an immediate basis. These people are extremely difficult to find, because not only do they need to be incisive analysts themselves, but they also need t oknow how to provide useful and actionable feedback. Most people in this world aren’t good at both of these things. I did have a larger circle of “peers” a while ago, but when I realized that the quality of feedback they were giving was fairly low and they did not reciprocate with their own ideas, I dropped them from my contact base pretty quickly. Sure I’ll still grab some beers with these guys but don’t really need them in my circles because I have enough trusted advisors. So yeah, my advice to you is to spend time with people that you trust, and you may find youreslf sending out more ideas than you receive, but anyone that can carve out time to give you feedback AND you trust them will be a relationship that you’ll want to nurture.

Reading materials? I’d say Margin of Safety is very valuable; same for The Art of Short Selling (my two favorite investment books). Then also read investor letters from prominent hedge funds. Sometimes they talk about their ideas, not necessarily in the form of a full-blown pitch but rather a snapshot of their investment thesis so at least you get a sense of what the key issues are.

Want one more thing to read? I’m doing an interview with Mergers & Inquisitions next week about hedge fund case studies, detailing my own experience with how to go through case study examples and my impression of best and worst practices. It sounds like you already have gotten some great help on your stock pitch already, but this should nonetheless be a good read once it comes out. Stay tuned.

#7

A couple more things:

  • As you realized, having someone to dialogue with investment ideas with is huge. That’s why people that work on the buy-side and have competent analysts/PM’s to banter with are generally at an advantage over people that don’t. Once you get to the buy-side I think you’ll have a very different appreciation for investing, but for now, anyone that can act as a mentor figure and whom you trust to do quality research and challenge your assumptions is someone you need to hang onto. With that said, these kinds of people are very difficult to find and usually some type of “quid pro quo” is involved, naturally – networks run both ways, they aren’t a unilateral thing.

  • Having said that, I’ll also add one VERY important piece of advice in that you should always be reflecting. Understand what you know, but more importantly understand what you DON’T know. Once you realize both these things, you will actually be much more confident in your own abilities, and a big part of being a successful analyst isn’t only by conducting the analysis, but also knowing how to communicate it with impact and conviction. You strike me as someone that’s pretty thoughtful and I’m sure on some level you (or I, or a lot of people) will somehow feel “insecure” that we don’t know EVERYTHING about a stock. But actually what matters more is understanding the key drivers, having conviction in those things, and being comfortable with a “take it or leave it” attitude with stuff that you don’t understand because if it’s not that important anyway, you shouldn’t be wasting your time on that stuff. What you should instead be doing is figuring out how to convey as much confidence in the things that matter, and have a view on those things. My guess is that you’re more prepared from having worked on this one pitch than even you might realize.

  • Good advice from Sweep the Leg – inversely, if you’ve made a bad stock recommendation or you’ve seen a stock pitch that you thought was good but the stock traded against it, really understand WHY the recommendation went wrong and try not to make the same mistake again. I recently made an error on an organic products company where I shorted it before the company reported earnings, stock missed in a big way and traded down about 10%. But I didn’t take profits then, and now it’s back up over where it was before due to short coverage and people to continue to buy into the organic/natural foods hype. Long-run I still think it’s a good short, but things can stay hyped up for a while and the saying that the market can stay crazy longer than you can stay solvent is definitely true. I’m now looking at another specialty CPG company as a potential short and will try not to make the same mistake again.

  • bromion’s recommendation on Porter’s “Competitive Strategy” is a must-read. All too often people focus on the financials but don’t understand the competitive dynamics. Competition is a fluid thing and if you aren’t able to anticipate changes in an industry, i.e. why companies operating in industries with currently high margins could be a BAD thing, you will get f*cked no matter how closely you look at the numbers themselves.

#8

You get a lot of mileage by comparing companies, rather than trying to decide individually if each one is over/undervalued on its own. That’s a big help when you’re starting out.

Ultimately, most people will still want you to make individual calls on companies, but you learn faster in the beginning by doing comparisons.

#9

Bromion’s right that dividends, earnings growth, and multiple expansion are the three categories of returns, and in the last few decades, multiple expansion has been where the big bucks are.

What a lot of people forget, however, is that one reason for multiples expansion has been that interest rates have been dropping pretty much straight through since 1981. What that means is that peoples’ discount factor is dropping, which pushes up multiples. This is separate from the multiples that happen because of euphorias, new economy, etc…

These days, it’s tricky to see how interest rates are going to drop any further, so the tailwind of general multiples expansion is likely to be over. Individual companies can still get multiple expansion if there is an expectation of growth that starts to get realized and people pile in, but the general growth in stock multiples is different.

#10

You’re right bchadwick. I think interest rates are more relevant for the broad equity markets than for any specific issue, although interest rates are somewhat relevant to all stocks, and highly relevant to certain industries and cap sizes. What I was referring to though was the migration a stock may undergo from the value camp to the growth camp independent of interest rates.

I don’t like these distinctions since they’re a bit clumsy, but for the sake of discussion, take your run of the mill “value stock” that is statistically cheap but that lacks “juice” (growing sales, earnings, or some other catalyst). The stock may go up, but it’s not likely to double or more unless it was really, really cheap (in most cases, due to some temporary problem, i.e., reversion to the mean).

A lot of times I have observed that a “value” stock will trade in a sideways pattern and then suddenly have an explosive break out as it’s rerated to “growth” for some reason (usually because the P&L comes to life, since that’s what most investors look at). So now you have growing earnings, and your value multiple becomes a growth multiple. At some point, if it keeps growing or if the growth accelerates, it becomes a momentum stock and goes parabolic.

In other words, actually, the best way to get paid with the least amount of risk in the stock market is to find low priced out of favor stocks that are destined to become growth stocks for whatever reason (almost always increased profitability). You get embedded multiple expansion that way as the ticker rotates into new “camps.”

Probably everyone is tired of hearing me talk about these two stocks, but AEPI and FBC are both good examples of this happening.

How in a supposedly efficient market can you have a perfectly solvent, well managed bank increase in price by ~250% in less than 6 months? To over generalize, what happened is the that the stock was not ownable by institutions due to the $5.00 rule (pre-split). Value buyers started buying both before and after the split, and then post-split people have discovered that FBC is now going to be consistently profitable with growing earnings, so the multiple is expanding. Then you have an earnings surprise of >20% last quarter (which, according to a news article on NASDAQ’s website, makes this a “momentum” stock). And the chart reflects all of this.

I’m not disagreeing, bchadwick, but I was referring to something unrelated to interest rates – it’s a thing called alpha, maybe you’ve heard of it :smiley:

#11

Interesting info. Never thought about “market segmentation” for equities.

#12

I think all of the general discussion about “value investing” etc. confuses the topic. Ultimately, markets are about buyers and sellers - you would think that’s obvious, but most texts, articles, sources, etc. all talk about buying cheap stocks (under whatever metric) but fail to mention anything of substance about who you are supposed to sell these stocks to. Cheap stocks just “magically” get less cheap somehow and then you sell (it’s so easy!).

I think that knowing who owns what stock and why, and what would make others buy or sell that particular stock (across disciplines) is almost the most valuable thing any investor could know (and it is knowable to a large degree). Clearly, this is not something anyone can be expected to immediately pick up from day one, it takes a long time to master this skill. But that’s what investing is when you really boil it down – you’re laying out capital with the expectation of getting more capital back in return at some future point. Better know how that’s supposed to happen.

For what it’s worth, I think this concept single handedly destroys (and badly) the efficient market hypothesis. EMH only works if you assume that all people are rational (they’re not) and that they’re all focused on the same metrics, time frames, and outcomes (they’re not). Inefficiencies exist, and you can capture them if you figure out what other people are doing and how to exploit them.

To that end, valuation itself is highly relevant, but I think it’s less relevant than a lot of people think. Valuation provides margin of safety. What makes stocks go up is an improving outlook. You could buy “expensive” stocks and still make money if you consistently get the incremental changes in the outlook correct. So from that perspective, I think you can actually say that nailing the directional changes is the most important thing in investing in terms of actually making money.

#13

^ We need to add a “like” function to this forum for posts such as the one above

#14

Bromion’s full of good thinking here. Kudos to him!

#15

you guys sure have a penchant for writing…

i would say 1) read a lot 2) practice

#16

Some awesome replies here. Thanks for sharing your thoughts guys. I’m going to sit down tonight and reread what’s been discussed here and start to formulate some sort of long term plan.

#17

Thanks for the props Numi. I’m glad I’m in the inner circle of AFers with a sound investment philosophy. Remember little people like me when you’re M’n’A’in on the Buyside.

#18

Sorry to highjack the thread, but Numi what do you think about investing in HF generally? Would you put money in from your personal account or 401k (assuming you had the funds available and it was possible to access good managers)?

My view: The fees are horrible and returns have been mediocre for the past couple of years but I still think a selection of good quality, low beta hedge funds can act as an effective diversifier in a balanced multi-asset class portfolio. However, I am becoming less convinced of their worth over time.

Back on topic - not sure if this has been mentioned because I haven’t read through everything but you should definitely practise making financial models for a sample company. Start by inputting recent years’ financial statements into excel, and then use a seperate worksheet to link in your assumptions for future growth. Then build out a DCF. Voila, you have now learned a lot about valuing a company.

#19

So when you’re modeling a company, how do you go about figuring out future revenue growth and future profit margins? It always struck me that the only two ways are really 1) extrapolating current growth for revenue, perhaps with some correction for market share, and 2) assuming some kind of mean reversion for profit margins (and some analysts don’t even do that).

Every once in a while, you’ll get management guidance on capex plans that will let you tweak things beyond simple extrapolation and/or mean reversion.

My issue with all the time and effort it takes to model a company is that the revenue growth and profit margins (gross, or net, or whatever) ultimately feel like sticking your finger in the air and feeling which side seems cooler in order to find true north. So I never feel all that comfortable with my results, and seldom enough to pull the trigger.

I like Bromion’s approach because he seems to be looking for big risks that are over/underappreciated (accounting fraud that will eventually have to come to light, some clearly overvalued/undervalued asset on the balance sheet, clearly unsustainable business models, etc.). How bromion does the timing aspect of this is still difficult for me to understand, but I like how he tries to find things that are missed when people just extrapolate past growth and perhaps tweak things around the edges.

#20

My solution to bchad’s problem is to simply project growth rates conservatively…one way to develop a margin of safety in valuation.