Monday, November 26, 2007

Morningstar Stock Investor: Seven Different Investing Perspectives

Recently, Paul Larson, an equities strategist with Morningstar, described seven ways in which his investment strategy differs from the conventional wisdom and academia ("Seven Different Investing Perspectives"). Mr. Larson definitely uses a long term strategy for investing, which is also my approach. Taking into consideration the views and strategies of a variety of advisors and analysts can be very helpful in shaping your investment strategy. A synopsis of Larson’s "seven investing perspectives" is included below for you to review.

Morningstar Stock Investor: Seven Different Investing Perspectives

1. Focus on the next decade, not the next quarter.

Most Wall Street analysts who publish research for public consumption spend a lot of their energy focusing on near-term tax rates, weekly inventory trends, and so on, which really do not matter in the long term.

The army of analysts on Wall Street serve an exploding number of hedge funds, entities whose investors demand performance - and demand it now - given the exorbitant fees usually being paid. Many hedge funds cannot afford to think about the long term, because if they suffer even a little in the short term, they might not be around for the long term.

Luckily, those willing and able to take a long-term perspective can gain an edge in this short-term-focused world, and that's exactly what I and our analysts do here at Morningstar. We spend a lot of our time thinking about where a company is going to be many years from now, because this is what drives intrinsic value. We try to minimize the short-term noise to pick out the secular trends that will really matter.

2. Price volatility does not equal risk.

If you go to business school, you are likely to be taught that risk in the stock market can be defined as the historical volatility in a stock's price. Risk is usually thought of and measured in terms of beta, a statistical measure that represents a stock's past volatility relative to an index. Frankly, I just do not understand the relevance of beta when thinking about ways I might lose money. Not only is it backward-looking, but its connection to intrinsic business value is tenuous at best.

When thinking about a stock's risk rating, Morningstar analysts do not focus on the past stock price movements of a company. Rather, we focus on the fundamental business factors - competition, litigation, financial leverage, and so on - to try to figure out what sort of margin of safety to apply to a company before buying it.

3. Price volatility is a good thing.

Not only do I think stock price volatility is a silly way to measure risk, but I actually like volatility. When stock prices whip around, it creates more opportunities to buy things when they go on sale. Moreover, volatility can fling stocks well above their intrinsic values, creating selling opportunities.

I think two of the more famous Warren Buffett nuggets of wisdom apply here. (Though Buffett is as mainstream now as he has ever been, he is still seen as a heretic in many academic circles.) According to Buffett, one of the cornerstones of his strategy is, "Be fearful when others are greedy, and greedy when others are fearful." The other Buffett quote that backs up my favorable opinion of volatility is: "Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it."

4. Concentration has its benefits, overdiversity its downfalls.

It seems that whenever I hear financial advisors speak, they are always preaching the benefits of diversity. While I agree every portfolio should have some level of diversity to prevent any single mistake from causing financial doom, I do not think the downside of diversity gets enough attention. Specifically, the wider you spread your portfolio around, the less you will know about any single investment, and the greater the chance you will miss something that is wrong. Call it the risk of ignorance.

In other words, I agree that it is good advice to not put all your eggs in one basket, but do not forget about the risks of trying to carry too many baskets. Or, to use our "fat pitch" metaphor, don't swing at the marginally decent pitches, because then your swings at the truly fat pitches will be diluted.

5. Bottom-up is better than top-down.

There are two basic ways to look at stocks. The first way (and what we do here at Morningstar) is to look at an individual company - its competitive positioning, profitability, growth prospects, and so on - to come up with an intrinsic value estimate for the business. We then compare this fair value estimate with the current stock price to come up with our Morningstar Rating for stocks (the star rating).

The other way is to try to pick out macroeconomic trends and generate investment ideas from these trends. Some examples might include ideas regarding the aging population, interest-rate movements, global-warming regulations, changes in consumer-spending patterns, and so forth. Some investors might choose to overweight or underweight their portfolios in certain sectors based upon their views of some of these trends.

The problem I see is that there are often too many logical links between the ideas and the actual stock investments. Even if your idea is correct, you could still select the wrong stock for that idea. Another pitfall of looking top-down is forgetting the importance of valuation and paying too much for a stock.

I also do not try to "fill the box" when managing the [stock portfolio]. What I mean by this is deciding on some sort of asset allocation - either by sector or stock style - and then picking stocks to try to fit my target allocation. To me, this is putting the cart before the horse.

What I do instead is look at each stock on a case-by-case basis, and I then let the cards fall where they may with respect to the sectors and styles of my holdings. Only at the extremes might I get worried (such as having more than half a portfolio invested in a single narrow industry).

6. Increased portfolio activity does not create higher returns.

In the real world, the more activity you have in a given area, the greater the return in that area, in general. For example, the more you exercise, the more weight you lose. The more you play golf, the better your swing will get and the lower your handicap will go, and so on. But when trading stocks, the exact opposite is true. In general, the more you trade, the lower your returns will be.

There are the frictional costs of taxes, trading spreads, and commissions that will eat into your capital every time you trade. Of even greater importance in my mind is the amount of thought that goes into each trading decision. It seems that the greater the thought-per-transaction ratio, the better our results should be, all else equal. I spend hours upon hours considering each transaction in the Tortoise and Hare, but spend mere minutes interacting with our broker doing the mechanical transactions, worrying about nickels and dimes. I get the impression that too many investors have this ratio reversed.

7. Focus on value, not price.

It strikes me that many in the market know the price of everything and the value of nothing. I will admit that there are scores of companies for which I know what the stock price has done, but have no clue about the value of the underlying business. But before I invest in something, there is no way I would put a single penny in without having some idea what the underlying business is worth. Knowing price without knowing value means knowing nothing.

I recently was asked if I had in place any stop-loss orders for positions in the Tortoise and Hare. The answer is a resounding "no." Making decisions based on historical prices makes no sense to me. Moreover, assuming that the intrinsic value of a business is unchanged, when its stock price goes down, that is the time to get more excited and consider buying more, not time to cut bait.

Of course, the key phrase is "assuming the intrinsic value of a business is unchanged." We are continually questioning our theses and projections for the companies we cover, always digging deeper for pieces of confirming or contradictory evidence. These fundamental factors - not stock prices or ideas about future market sentiment - are what drive our fair value estimates.

John Kaighn

Jersey Benefits Advisors

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