It used to be that the most important tool that you needed for picking stocks was a subscription to Value Line. It was by studying the numbers that you gained an edge.
Many question whether it is possible to gain an edge anymore just by studying the numbers, given the widespread access of fund managers to databases that slice and dice the publicly available data in dozens of ways. Does the individual investor need to give up picking stocks?
Not necessarily. Investing is primarily an emotional endeavor and only secondarily a rational one. It remains possible today to gain an edge by developing insights into the behavioral aspects of investing. The fund managers generally have no particular edge on that score.
This article lists eight ways in which an understanding of behavioral finance might help in picking stocks today.
Edge #1 for those picking stocks today — Investors overreact to bad news.
The stock prices of companies that are stigmatized because of lawsuits or public relations fiascos can drop to very low levels. In cases in which the companies involved are not strong enough to overcome the challenge, you don’t want to get involved. In cases in which they are, buying your piece of the stigma can provide a long-term payoff.
Edge #2 for those picking stocks today — Boring companies generate non-boring returns.
Two companies have the same profit-generating potential. One is involved in a sexy business. The other isn’t. Which one has the higher stock price?
Most investors love story stocks. That opens up an edge for those willing to seek out non-story stocks. Boring can be good.
Edge #3 for those picking stocks today — Starting the wild ride at the right spot.
Check out Apple’s price history. It’s a story of wild ups followed by wild downs. Either investors believe that Apple is about to take over the world or they believe it’s about to go under.
It makes no sense at all to invest in a company like this when its price is high. But how about when its price is low? When the price is low, there will be reports that the company may be about to go out of business. And those reports might be right. If they are not, though, the company might be able again to take advantage of the resources that permitted it to rise from the dead before. Buying low gives you a high-risk shot at an attractive return.
Edge #4 for those picking stocks today — Buy up companies that will be buying up companies when prices drop.
Stocks are highly overvalued today (this article was posted in February 2007). That’s not always going to be so. When prices fall, the economy will likely stall and many companies will be desperate for capital. Companies that are heavily in debt will be vulnerable to buyouts.
Berkshire-Hathaway has lots of cash available to take advantage of such opportunities when they open up. So does Microsoft. These are the sorts of companies that might benefit from developments that will cause trouble for lots of others.
Edge #5 for those picking stocks today — Dividend-payers are straight shooters.
Investors who disdain dividends often argue that it is better for the company to be using the funds to fuel quicker growth than to be distributing them to shareholders. In theory, dividend-payers should grow more slowly than non-dividend-payers. In reality, it often works out just the opposite. Dividend-payers often grow faster.
How come? For the same reason that those who give to charity often live full lives themselves too. Giving is a sign of strength. Many companies that pay good dividends do so because they can afford to pay good dividends; they are strong companies.
The dividend that a company pays is not just a number. It is a behavioral sign of the strength of the corporate enterprise.
Edge #6 for those picking stocks today — Integrity matters.
Warren Buffett would never put his money down on a stock without knowing all the numbers inside and out. But he argues that the numbers are not the most important thing you need to know about a company. The most important thing you need to know about is the management. The most important thing you need to know about the management is its reputation for integrity.
It’s sometimes hard with large companies to gain a sense of what sort of people it is who are driving the business. When you can, it’s the sort of information that can provide a profit-generating edge. You need to be capable of patience. It’s not an edge that always pays off immediately. But integrity usually makes a big difference in the long run.
Edge #7 for those picking stocks today — Companies need to practice buy-and-hold too.
They tell us individual investors that we need to “buy and hold.” Why is that so important? It’s because it takes time for investing strategies to pay off. If you jump from this to that and then to the other thing, you never get anyplace good.
Companies too should stick to their strategies. Before looking at what the company is saying about itself today, check what it was saying about itself five years ago. If the message has changed in a way that is not part of a natural growth process, I would step away. If the company seems to be advancing in pursuit of a long-term vision, it might be that you have an opportunity to tap into the benefits of that vision just before it begins paying off.
Anyone can say that they are pursuing a vision. You need to see a demonstrated commitment over a significant amount of time before putting money down behind an idea. If a company has shown that it cannot stick to a vision through a number of struggles, you as an investor should not want to be involved. It’s often worth taking a chance on those who have demonstrated the courage of their convictions.
Edge #8 for those picking stocks today — You’ve got to stand for something.
When I was hiring, I didn’t look only at the skills possessed by candidates I was considering. I looked for a story in their resumes. What was it they were trying to accomplish in their careers? How did they bounce back from frustrations? How creative were they in overcoming obstacles? Was there a logic to their career paths, or were they jumping from one ill-considered notion of how to move ahead to another?
Some companies are a mishmash of ideas that made sense once upon a time. I like a company with a strong identity. I like a company that stands for something. Companies (and employees) that stand for something don’t always succeed. Even when they don’t, you usually learn something from being involved with them.