A Conglomeration of Ideas

The most important thing when choosing a stock is the ability to think for yourself. In the article, “Stock Selection: How to Be a Star?” it was found that the more that managers responded to recommendations by analysts, the worse that the fund performed. Successful managers have an uncanny ability to ignore the constant stream of information coming from the media with regards to the securities market.

The Journal of Finance found that investment returns were highest in the world of private equity, in which endowments and pension funds were the stars. David Swensen, the endowment manager for Yale, is the prime example of why the endowments have a 21% better than average return as compare to other funds. He has a disdain for measuring the quality life in monetary measures. Warren Buffett has a similar world view, living in modest homes and eating modest meals.

Money doesn’t provide long-lasting satisfaction. Autonomy, meaningful contact with others, and development and exercise of competence, all internal rewards, do. The pleasure from money and other material goods is fleeting. The American workplace recognizes the external over the internal, and to avoid failure, people forget to engage their skills and destroy their ability in the pursuit of high compensation.

The best money managers are paid relatively little. The job to them isn’t a paycheck – it’s a calling and a passion. When investing, it is advised to think about things the same way, and to look at the data yourself, and make sure that the company you are choosing is an investment company, not a company entirely driven by the want of money.

But how do you choose a good company?

The article, “Bargains, Anyone?” (2013) expands upon this. It discusses a 2013 rally, where all but 40 stocks in the SP 500 were up. The SP 500 had jumped 16%. There was speculation that these 40 stocks wouldn’t catch up to the rest of the broad market.

These stocks are being evaluated to see if they are undervalued and underappreciated, since they do have such low prices. But a low share price doesn’t equate to a good buy. As Meir Statman says, “Losers continue to lose (sometimes for up to 2 years)”.

Most sectors were seeing double-digit increases in growth, and gold was down 31%.

It is important to consider that the stocks that have already risen might continue to rise as well. Mr. Statman’s final words of advice were, “Let your winners run and cut your losers short.”

The article “A Simple Method to Pick a Winning Stock” had a different piece of advice. They recommend looking for stocks with the highest amount of gross profits (Gross Profits equating to Total Sales minus Cost of Goods Sold). They advise looking for the greatest profitability – not the greatest amount of earnings.

To compare companies, divide gross profits by total assets to get the gross profitability percentage. Interestingly enough, the company with the greatest gross profitability is a staffing firm called Robert Half International, followed by Estee Lauder.

These companies are highly profitable, and NOT highly volatile, which is an incredible combination.

Of course, it is important to look at numerous metrics when evaluating companies. But gross profitability [(Total Sales – COGS) / Total Assets) is another metric to add the toolbox.

Companies are taking many steps to become profitable. As the article “How do you Search for Tomorrow’s Winners?” discusses, companies are open factories closer to customers due to rising labor and transportation costs and worker shortages. These “Western” factories are used more for customization and premium goods.

However, the goal for one factory is to have a movable platform with arms that can be reprogrammed to different tasks. Automation can replace human labor on repetitive tasks and can increase quality standards across the board. Machines can produce products more quickly and produce more complicated designs.

Automation, however, isn’t the goal. There are still tasks that require some human touch. Human dexterity is still a key part of the process, and will continue to be.

The article “Surprising Recommendation” has an interesting viewpoint on shareholder involvement in companies.

There is something the author calls “the capital cycle of corporate-investment surges followed by entrenchment”.  This is something that happens when “high returns attract capital, breeding excessive competition and overinvestment.”

The ideal company, in this author’s eyes, would invest at a minimum and return profits to investors by working in an uncompetitive industry.

Investors bid up shares when they see opportunity, based on the notion of rising demand. They never really notice when supply rises to meet it, and thus end up with “too much of a good thing”. This drives up competition and thus drives down future profitability.

Eugene Fama has looked at corporate investment in his work, expanding his 3-factor model into a 4-factor model of drivers of return – corporate investment, value, momentum, and size.

When companies invest LESS, they do better because their starting valuation is lower and there is less pressure. Margins are higher and stocks do well. When shareholders push companies to invest in that point of the capital cycle, it leads to low profitability. It’s best to return spare cash to investors in some other way.

Overall, it is important to look at many different things when choosing stocks – both metrics and news sources. A new factory opening up could mean a potential buying opportunity. An overinvested stock in an overly competitive industry could be a selling opportunity. A company with a high gross profitability percentage is a key buying opportunity, based on research. And companies that have been falling for a while might keep on doing just that – so we have to look at things from multiple angles.

The most important thing of all is to possess the ability to critically think about the stocks that you are looking at. Look past the overgrazed investment commons and analyst’s recommendations. We want to avoid the adage “live by the buzz, die by the buzz” and derive our own value from our own private evaluations. Think for yourself.

Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.

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