Chapter 25
Why I can’t pick winning stocks and
you can’t either
Don’t feel bad. As we’ve seen, most professionals can’t either.
Indexing vs. active management is always a fascinating debate; at least for us stock geeks with nothing better to do. Over the decades I’ve been on both sides of it. For a very long time I laughed at the indexers. I made all of the arguments, and then some. After all, if you just avoided the obvious dogs you’d do better than average, right? As we saw in the last chapter, it’s not that easy. But in the summer of 1989, I was still convinced I could win this game.
On a flight back from a business trip, I happened to sit next to a guy who worked for an investment research firm. By the time the flight landed he had suggested I should join them and, at my request, had offered three stock tips. I picked one at random and bought it. Over the next several weeks I watched it triple and by the end of that time I had taken a major pay cut to join the firm in a major mid-career change. Who cared about the salary?
The real money would be in the information flow.
There I was, surrounded by the exceedingly bright analysts this firm employed. Each focused on one, maybe two industries and within those industries perhaps 6-10 companies and their stocks. More than one had been honored in the trade press as “Analyst of the Year” for their work.
These were folks at the top of their game.
They knew each of these industries, and the companies in them, inside and out. They knew the top executives. They knew the middle managers and the front line people. They knew the customers. They knew the suppliers. They knew the receptionists. They spoke to them all weekly.
Sometimes daily.
They still didn’t get critical information before anyone else (that’s insider trading and foolproof, but illegal). But they did know exactly when and how such information would be released. Of course, so did every other competent analyst around the world. Any new information was reflected in the stock price within seconds.
They issued reports for which our institutional investor clients paid dearly. And yet, accurately predicting stock performance remained frustratingly elusive.
If you’ve worked in a major corporation it is not hard to see why. The CEO and CFO work with internal forecasts created by their teams. The process looks something like this:
Salespeople are required to forecast what their customers will spend. Since these buys are rarely locked in far in advance, and can be cancelled any time, nothing is truly certain. Add to this all the pending business that may or may not come to fruition and basically you are asking the field salesperson to predict the future. Typically they are not clairvoyant. So, of course, they take a guess.
These guesses get passed on to their managers, who are also not clairvoyant, and who now have their own forecasts and decisions to make.
Do I take these sales forecasts at face value? Do I adjust them based on knowing Suzy is an optimist and Harry always sees dark clouds? So, of course, they too take a guess and pass it on to the next layer of management.
So it goes until all these guesses on the inherently unknowable future are consolidated into the nicely packaged budget/forecast binders presented to top management. More often than not, after one look, they’ll say: “This is unacceptable. We can’t present this forecast to Wall Street. We need more positive results. Go back and revise these numbers.” Back down the chain it goes. Maybe multiple times, and each time the numbers get pushed a bit further from reality.
Predicting the future is a dicey proposition for even the most gifted psychics, and they are not burdened with this process.
Suddenly, my enormous stock picking hubris was clear. Somehow 7 reading a few books and 10-K annual reportswas going to give me an edge? Over not only the professional analysts who lived and breathed this stuff all day every day, but also the executives who run the companies in question? I could succeed where they could not?
Suddenly I realized why even rock star fund managers find it almost impossible to best the simple index over time. And why more fortunes have been created brokering trades than making them.
I cringe at the oft-made suggestion that an investor can read a few books on valuing stocks and go on to replicate Buffett’s results. Perhaps the best of these is The Intelligent Investor written by Warren Buffett’s mentor, Benjamin Graham. It is a great book and if stock analysis interests you, by all means take the time to read it.
But remember that when Graham wrote it in 1949, Jack Bogle’s first index fund was still 25 years away. Even actively managed mutual funds were few and far between. Analyzing and choosing individual stocks then was a far more necessary and useful skill. But as early as the 1950s, Mr.
Graham was warming to the concept of indexing and by the mid-1970s in interviews was fully embracing its value.
The idea that individuals can readily outperform the market is, to steal a phrase from my dad, horse hockey. Dangerous horse hockey at that.
People have been trying for decades and yet, there is still only one Warren. Think about it this way:
Remember Muhammad Ali? He was the Warren Buffett of boxing in his day. You and I could have followed his training regimen, maybe even engaged Angelo Dundee to show us the ropes. We could have gotten in top shape, done all our homework, learned the “sweet science.” And, after all that effort, would you climb in the ring with Joe Frazier or George Foreman or Sonny Liston?
Not me. I’m no Ali. Or Warren. Neither are you. (Unless of course you are, in which case: Thanks for picking up my book!)
Having read the last chapter, you know what Warren Buffett recommends for individual investors: Low-cost, broad-based index funds.
Graham, were he still alive, would too.
If you choose to try to best the averages, God Bless and Godspeed. You may well be smarter and more talented than I. You are most certainly likely to be better looking. I’ll look for your name along with Warren’s in the not- too-distant future.
I extend the same to all those folks I’ve met in Las Vegas who assure me they have bested the house. I listen, gaze up at the billion dollar casinos and reflect on how many smarter, more talented and better looking people there are than me.
A little humility goes a long way in saving your ass and your cash.