Investing == Predicting The Future

Investment Analysis Clubs Saul’s Investing Discussions
1

Lately I’ve been thinking about what really makes a successful investor, which to me means understanding what investing is all about. I posted something similar on one of the TMF paid boards, but thought it would be a better topic here, since it does relate to Saul’s strategies.

Let’s start with the fundamentals. There are 2 fundamentals reasons to buy stocks:

  1. The company will pay you some of its profits (as dividends) on at least a semi-regular basis.
  2. The company will grow in time and be worth more in the future. But, you don’t actually get this growth money until the business is sold.

Now, people don’t like to make forever decisions. They may not want to own a piece of a business forever, or until that business is sold. There are a variety of reasons for wanting to sell, ranging from putting the money to other uses to thinking the business is no longer the best place for your money. Hence, the Stock Market as a convenient place for people to buy and sell pieces of businesses came about. Technology has taken the Market from meeting with face to face with brokers to written/mailed instructions to talking on the phone to clicking a mouse.

But having a Market in which to buy and sell pieces of companies creates new opportunities to make money. Now, instead of buying a company to get a share of its profits, you might buy a piece of the company because you think you can sell that piece to someone else for more money later. I think of this as a “second order effect.” And, of course, options on stocks are a third order effect. Instead of buying/selling stock, you buy the right to buy/sell stock, and you can sell that right as a thing in and of itself!

Anyway, what’s obviously happened is that the second order effect dominates much of investing today. Yeah, some people are dividend hounds, and that can make sense as part of a portfolio, especially a retirement portfolio - but the real meat today is the familiar “Buy Low, Sell High.” And unless you’re big enough to get in on an IPO, when you buy you’re bidding against other potential buyers.

And so what I believe it comes down to is whether one can predict the future of a company’s business better than other people can. For instance, TSLA used to be cheap because most people thought that no-one could be successful starting a new car company (after all, for many decades many had tried and failed), much less an electric car company, much less that company being run by people with little to no automotive experience. But, when Model S was successful, more people thought the company could be successful and so were willing to pay more to own a piece of the company. But now, with TSLA over $200/share, is too much of the company’s potential already priced in?

Similarly, Amazon doesn’t pay a dividend and hasn’t had 4 straight quarters of profitability, yet the stock is over $750 a share today. Sixteen or so years ago it was an open question whether Amazon would be a huge success, but today the question is whether too much of the almost universally-agreed future success is already priced into the stock.

Successful investing is out-guessing what hundreds of thousands, if not millions, of people are thinking the future holds for these companies.

And so I believe the challenge for us is literally predicting the future better than other people can. When you think about it that way, it’s a scary thought. There are professionals with lots of people and money resources doing this. Can we amateurs really be better? Are pros really limited by short term constraints hampering their ability to do a great job? Are so many investors emotional that the prices don’t reflect what the odds really are?

And turning this around to all the number crunching and metrics that we use - whether it be P/E ratios, YPEGs, same store sales, whatever/etc. - all the pros know and do this stuff. Does buying Skecher shoes for ourselves really give us an insight into the company’s future better than professionals trading on the same market exchanges? Or, are we fooling ourselves into a sense of security because our instincts happen to be good, as least for some time measurements? I note that Anurag has pointed out that only one of the TMF real money services has produced better than its target index over a period of 5 years or more. In other words, TMF has had some great picks, but they’ve also had some lousy picks, and when they forced themselves into a real money portfolio model their end results were almost always not better than if they had just bought index funds.

So the question I’m grappling with is whether I’m any better at this than Tom, David, and all the other smart people at TMF. Are you?

27 Likes
2

So the question I’m grappling with is whether I’m any better at this than Tom, David, and all the other smart people at TMF. Are you?

If I were doing the same thing as “Tom, David, and all the other smart people at TMF,” probably not but by approaching the market differently one can still outperform the pros. If you scan the headlines on any given day you see one guy saying the market is going to go though the roof and the next expert saying it’s going to tank. Taken together you get the famous “consensus” which is not a consensus (general agreement) at all but an average of disparate outlooks.

There is the idea (and your post implies it) that we are in some kind of hand to hand combat. I posted about it at the options board:

Who’s on the other side of your trade?

http://discussion.fool.com/who39s-on-the-other-side-of-your-trad…

and the conclusion I arrive at is: “An OptionBot!”

I think that worrying whether one is better or worse than Tom, Dick, or Harry is a waste of time. Better to just focus on one’s goals making first sure that the goal is realistic.

Denny Schlesinger

14 Likes
3

Great Post!
I say this because I think about this quite often. In general, I have a hobby of reading investing books and articles. Whenever I come across these type of articles, I’ll call them “efficient market” articles, it makes me evaluate why I do my own investing. I think it is a very valid question, and you don’t have to believe in the efficient market, per se, to understand that it is a valid question.

The real question to be asked is why you think you can do better than the market overall. With many very smart people spending all of their waking hours studying this stuff why do I think I can do better than them? Or even the market as a whole? After all the s&p index funds do pretty well, actually much better than most mutual fund managers. So again, why do I think I can do better than these smart mutual fund managers who have been trained and schooled and spend all of their the doing exactly the same thing.

And the answer is, probably on my own, I can’t. But I am not on my own. I have found a community here, with both the paid subscription services and free boards that help me. They help me find good stocks, they help me stay calm when others are not, and they help me stay focused on the big picture.

But again, even with that, I will come back around to why I can do better and shouldn’t I just allocate my portfolio, buy index funds, and redistribute once a year to keep it all in balance.

The truthful answer is that I could do that and I would still do better than most people. It is definitely not a bad option, but I think I can do better…

Here are my reasons why:

Most money managers are focused on the short term. They have to be for very good reasons. I.e. If they don’t and have a bad quarter or year, they get replaced.

Fees can kill you. Even with my own trading and costs of TMF, my transaction costs are very low. Much less than a half percent. Even when mine were a little higher costs, I felt I was learning the trade so that when I did have a decent chunk of money I would be able to do what is I am doing today.

The market is rigged in your favor. Finding good companies, at good prices isn’t that hard if you take your time and don’t trade often. Buying a portfolio of say 20 or more stocks and holding them for the long term, should allow you to at least match the market. The key is to not jump every time a price changes…the short prices are what the mutual fund managers have to worry about. How many times do you see a sell recommendation that says in the long run they are fine but the next couple quarters are going to be tough. These are great situations to buy a little, add as it goes down and then hold for the long term.

It doesn’t take many winners to make up for a lot of losers. I use NFLX as my go to example here. I bought some years ago when it was under $20. Added as it went to $60 or so and then started a very slow selling process as it continued to climb. By the time it hit $300 the first time I had taken out a good chunk and it still represented a significant part of my portfolio. This allowed me to not panic and get out when it dropped down to $60 again. I had already taken out quite a bit. Now it is back up again and is my 3rd or 4th largest position and I have taken about twice as much out as I still have in. My last sale was at 120, late last year I believe.

Owning individual companies allows me to feel better when the market drops. I never thought of getting out in '08 or '09 because, come on, if APPL or BRK went under, it wouldn’t matter what I owned. So I held, continued to add and was higher less than two years later. If I had owned index funds, I think I would have been more likely to just get out for a little while because it would have been easy to do so.

As I get closer to retirement I can slowly move to lower risk companies that pay dividends. This helps in taxes and makes the process of deciding what I can take from my portfolio much easier as most of the income can be dividends.

Finally, because it is fun. I like the control I feel that I have and having done this few a while now makes me confident I can do it in retirement as I practiced on smaller sums…

Now the truth is there are a lot of people who probably should own index funds. It really is a good choice… Just not for me

Randy

24 Likes
4

Some things that tend to work:

  • be a long term optimist even when short term crises occur. Buffett is the great example here. He has great faith that capitalism unleashes the best in humanity and that the long term future will always be much better than today. Read his last annual letter for some great language on this.

  • invest in things that will last, great brands, companies with other great moats. These are more likely to survive the test of time. Thinking about the moat is a key. Watching for things that could change the story is always important. Avoid fads. Avoid unproven “Next Big Things”. Avoid stocks selling at very high multiples that already have huge growth priced in.

sw

3 Likes
5

So the question I’m grappling with is whether I’m any better at this than Tom, David, and all the other smart people at TMF.

Let me play cynic for a minute.

If you’re going to compare yourself to others (which is only rarely a good idea in the first place), be very careful to whom you compare yourself.

Tom, David, and the other “smart” people at TMF (and a whole lot of other dispensers of investment advice) are not necessarily actually investing to make money by investing. Many of them give investment advice to profit from selling the advice rather than from the advice itself. They are spinning stories to get you to pay for the story. The investment picks themselves only have to be better than horrible to keep collecting fees for the advice.

“We’re confident this is a short-term correction.” “We stand by our earlier analysis and feel that the market will come around sometime during the next two quarters.” Comments like these (which are my own fabrications from whole cloth and cannot be attributed to any particular investment adviser) are what keep people buying advice over time.

The big problem with investment advice is that you really can’t tell whether it good, bad, or mediocre until long after the fact. And most advice is based on subscription models - a newsletter for $X per quarter or X% of AUM per year. You buy it and keep buying it out of habit.

To me, real investment success isn’t about doing better than any particular person or group of people. It’s about growing money for future use and avoidance of expensive mistakes. If your money is growing over time and is on track to provide for your reasonably anticipated future needs, that’s the most important thing. Being better than someone else is only good for bragging rights.

If you need to feel better about yourself by comparing yourself to others, compare yourself to someone pretty bad at investing, like me. :wink:

And if you simply don’t feel up to the task of predicting the future of individual stocks, buy a couple of broad market index funds, then start taking walks around a park and smelling a few flowers. You’ll still do better than roughly half of the investing population (and better than about 2/3 of those “smart” investment advisers) and you won’t be making any massively wealth-destroying mistakes.

–Peter

20 Likes
6

If you’re going to compare yourself to others (which is only rarely a good idea in the first place), be very careful to whom you compare yourself.

This isn’t personal. If you can’t beat the SPX or the RUT or the RUI, then you should just buy those and save yourself a whole bunch of time and effort. We need a metric against which to compare our success.

Tom, David, and the other “smart” people at TMF … are not necessarily actually investing to make money by investing.

Well, TMF has had the balls to create a number of real money portfolios to prove that their investment strategies would beat the market. So, even if they’re struggling, I gotta give them huge props to be willing to do this in a very up front and transparent manner. If nothing else, I think they’re learning from it, and we (or at least I since I’m spending money with them) get to learn alongside them.

6 Likes
7

There is the idea (and your post implies it) that we are in some kind of hand to hand combat.

I did not imply that, and I believe I was quite clear that the comparison is to serve a simple end goal of making more money. If I can make more money by investing in RUT or SPX or following a TMF real money portfolio, I’ll do that instead of trying it on my own.

My concern remains that to successful one has to predict the future of the companies in which one chooses to invest. I don’t know that I can do that. Can you really do that? Ten years ago did you have predict that Amazon would develop AWS into a major profit center? Did you predict that Starbucks would just grow and grow while Chipotle would hit a wall?

Yeah, there’s no way to predict major bad events like food poisoning outbreaks. But I also believe there was no way to predict that an online bookseller would become the world’s retail giant. It’s a lot more obvious today, but you’re paying 10X more for the shares now.

The Russell 2000 is an interesting index that way. It “skips” over the top 1000 companies to include the bottom 2000 companies on the Russell 3000 list. That could mean it has more potential for growth since it catches companies on their way up to the Russell 10000 before they get there. But, it could also be catching companies on their way down out of the top 1000, or catching companies that will never make it to the top 1000.

Pragmatically speaking, since most compare to an investing formula not originally intended to be an investing vehicle (S&P 500 - which is a tracking vehicle, not investing vehicle), there are probably other formulas that will do far better. Perhaps subsetting the Russell 2000 to include only those companies rising in rank over the last 5 years? Any other thoughts?

And, how to compare to Saul’s strategy? He uses numbers like 1YPEG, but he doesn’t have a formula that says buy or sell. Sometimes at the end of a month he reports sells to stocks he had just recently touted strongly (SWKS comes to mind). There’s often not a number/equation/formula spurring him to sell, so it’s hard for us non-Sauls to reproduce his results.

Again, if the S&P 500 is so good it beats most analysts, then it should be feasible to design a different formula that does better at something the S&P 500 was never meant to do in the first place.

6 Likes
8

the challenge for us is literally predicting the future better than other people can

I don’t think beating the market is difficult.

Just put your money into a small selection of quality compounding businesses.

I would suggest MIDD TDG MKL GOOGL AMZN SBUX V MA CASY DIS

Go away for ten years and you will beat the market no problem.

But that is too easy, so instead we spend our time diving in and out of speculative story stocks, semi-conductors etc. And wonder why it is so hard.

Now I will retire to a dark room and try and work out why I am incapable of following my own advice…

Ian

23 Likes
9

This isn’t personal. If you can’t beat the SPX or the RUT or the RUI, then you should just buy those and save yourself a whole bunch of time and effort. We need a metric against which to compare our success.

Saul’s performance from his annual and monthly reports:


		**Saul	SPY	IWM**
			
2014		-9.8%	13.5%	5.0%
2015		16.0%	1.2%	-4.5%
YTD		-0.1%	7.6%	8.4%
			
**annualized	1.7%	8.5%	3.3%**

I suspect that there are many readers of this board with negative performance.

No disrespect to Saul, by the way.

9 Likes
10

Now I will retire to a dark room and try and work out why I am incapable of following my own advice…

Ian

I think I have the answer and it goes back several million years, while the homo species was evolving. According to lectures I have been watching, early man hunted by chasing down large herbivores by running after them, what is called persistence hunting. They would literally run them to death. That’s when we got used to chasing “food” or “yield” or anything else.

Persistence hunting

https://en.wikipedia.org/wiki/Persistence_hunting

It’s darn hard to shake a habit that helped us survive!

Denny Schlesinger

2 Likes
11

Saul’s performance from his annual and monthly reports:

Hi Aguila Azim, I guess it depends on where you cherry-pick your results from and to. You picked a particular two and a half year period to make my results look bad. Indeed you found I trailed the S&P by almost 6% and the IWM (whatever that is) by about 1.6% per year.

Let’s try some longer periods. How about the 10-year period from Dec 31, 1998 to Dec 31 2008 (includes the Internet bubble busting and goes right to the bottom of the Great Recession!) If you check on my yearly results you’ll see that at the end of that period I had 6.835 times as much as I had at the beginning, which means up 583.5% in 10 years.

The S&P, as it happens was DOWN 26.5% over those 10 years, to 0.735 times what they started with (from 1200 something to 900 something). I’ll let you annualize it out.

You could try the succeeding 10 years, or the 10 years after that, or the preceding 10 years, and get roughly similar results. Makes your little two year results trailing by 6% look pretty puny, doesn’t it.

Saul

By the way, having that 6.8 times as much to invest now makes such great returns a lot harder to attain.

3 Likes
12

Hi Aguila Azim, I guess it depends on where you cherry-pick your results from and to. You picked a particular two and a half year period to make my results look bad. Indeed you found I trailed the S&P by almost 6% and the IWM (whatever that is) by about 1.6% per year.

Saul:

Respectfully, his post is VERY important to those who just started following your investment methodology. They don’t have the benefit from previous years’ gains. It is NOT cherry picking to use time frames when they started…and you largely began publishing your methodology on jan 2, 2014 on this board.

Along with another post by Tecmo regarding what would happen had one held “Saul stocks” this past year…very educational for the newcomers IMO.

Neither poster is being critical of you personally…but everyone here including yourself should welcome outside scrutiny…so long as it is not hostile which neither poster has been.

Both posts should generate questions and not rebuke. For example, if your results have lagged the market these past couple years, then why? Are there market or macroeconomic circumstances that make your methodology less sound and might require some permutation. The classic teaching is that NO methodology works at all times whether value, momentum, growth or others…is this all we are seeing…a segmental cycle where the Saul methodology isn’t as effective than the general market?

Or how about what I already mentioned as regards this being a heavily time intensive process that if one let grow a couple weeds, returns would be horrible.

I hope you will not be so defensive and allow/embrace these discussions to take place in earnest…they might even assist you in your future returns?

Let me also praise what you do here…very few people would open themselves up to all that you share, no clothes and all. I know that it has required a great deal of energy from you and a pure gift to readers.

48 Likes
13

IWM (whatever that is)
Yeh that left me wondering. Don’t they make swiss watches?
A

1 Like
14

“very few people would open themselves up to all that you share, no clothes and all.”

I believe that your investing moves you make change because of the above statement. When you try and hit a baseball in front of 40,000 people you can alter your mechanics.

Robert

3 Likes
15

Ant,

IWM is the iShares Russell 2000 Index Fund.

Gene
All holdings and some stats on my profile page
http://my.fool.com/profile/gdett2/info.aspx

16

It is NOT cherry picking to use time frames when they started…and you largely began publishing your methodology on jan 2, 2014 on this board.

Anything less than a 5 year time period is meaningless.

2 Likes
17

I have nothing to gain from this discussion, so I won’t continue it. I was just pointing out an elephant in the room that I thought some readers maybe had not seen.

All I will say is: There is a reason for the disclaimer “Past performance is not necessarily an indicator of future results.”

Good luck with your goal of 20+% on average over the next 5 or 10 years.

9 Likes
18

For example, if your results have lagged the market these past couple years, then why? Are there market or macroeconomic circumstances that make your methodology less sound and might require some permutation. The classic teaching is that NO methodology works at all times whether value, momentum, growth or others…is this all we are seeing…a segmental cycle where the Saul methodology isn’t as effective than the general market?

I’ll take a stab at trying to answer this one. The primary issue for this particular timeframe is that Saul is heavily invested in stocks that are growing at a very fast rate, with a big open field in front of them to expand into. With the exception of Amazon, most of these companies are not massive. Some are mid caps, and a lot of small caps. Going for growth stocks for returns requires you to target a lot of smaller companies, because the massive ones can’t sustain their rate of growth. The issue though, is that from an institutional viewpoint, a lot of these growth stocks don’t have a very big moat.

I’m not a huge fan of the labeling of a particular company as having a wide moat or a narrow moat, or none at all. But basically a moat is just what it was for thousands of years, and especially in the Middle Ages - a means of protecting the castle when it is under attack by outside forces. A company with a wide moat typically has little debt, or at least low debt compared to its cash flow. The company also has stable recurring revenue that isn’t going to go anywhere anytime soon. In the event of a short attack, or global market issues, the wide moat companies are safe havens where capital can be preserved in most situations, except for a massive recession. The narrow moat companies fluctuate a great deal in price, and at the slightest hint of bad news get sold off rapidly.

The reason why moats are important, is because we are still in a long bull market, though arguably a sideways bull market that hasn’t progressed much. The current market is propped up by the Fed’s policy experiments, and there isn’t an enormous amount of confidence in the market compared to other bull markets in the past. Central banks, which profit pretty heavily off of the current system, at the expense of the rest of the economy, are pretty careful with their money. Because bonds are at such a low interest rate, even negative in some countries now, big banks and hedge funds that normally wouldn’t invest in stocks are really forced to do so, but without much optimism. A lot of institutional money makes its way into wide moat companies, like the FANG companies, Johnson & Johnson, and a bunch of others. The institutional money that gets invested in smaller companies is a lot more volatile. At the slightest hint of bad news, whether it be not meeting estimates for revenue or EPS (even if only two analysts cover the company, and both are completely different estimates), or if guidance is revised, or another short article with some merit gets published - the institutional money gets pulled out of that stock, almost immediately. Moving millions, and sometimes billions of dollars like that very adversely affects the stock price of a smaller company.

Add in the effect of the price uncertainty with oil, and the market has been pretty volatile lately. The S&P 500, which has a lot of pretty wide moat companies, does pretty well in most situations, aside from an all-out recession. When P/E starts tanking across the board during a major recession, the S&P 500 just hemorrhages money. In times of slow market growth though, especially with the housing crisis meltdown still a recent memory, a group of wide moat stocks like that is pretty attractive for institutional money.

Will Saul’s returns beat the S&P 500 in the near future? I think so, but it all depends on investor confidence in the market. LGIH’s returns have been great. We can’t have all of our money in it though. By diversifying across multiple companies we’re protected from some risk. At the same time, all these companies that keep growing rapidly, at the slightest hint of bad news they can erase most of the gains that you got from LGIH, SHOP, or other well-performing stocks.

10 Likes
19

I have a very different sense of moat than you do, Welgard. Yours seems to be entirely about finance, i.e., good cash flow and little debt which makes a company in a strong financial position. Well, yes, that certainly can help, but in any tech field, a merely strong financial position can be a thin tissue of protection. Real moats come from patent or trade secrets that mean that you know how to do something important that other people can’t do without infringing on those patents. One can have a moat based on brand, but chances are that unless that brand is supported by real differences, not easily copied, it is ephemeral.

20

“Good luck with your goal of 20+% on average over the next 5 or 10 years”

Yes and good luck with the rest of your life.

Frank