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by Mario Mainelli

This is part of our series written exploring the myths in popular investing as exposed in Michael Dever’s new book, “Jackass Investing.” In the book, Dever uses experience from three decades of hedge fund management to explore how the conventional wisdom in investing and portfolio management preaches little more than gambling.

Myth #8 in the book shows the true contrast between investing and gambling. To most people, gambling implies betting in a casino or through a bookie, while investing implies placing trades in the financial markets. The term gambling has a connotation of taking unnecessary risk without considering all of the factors that could affect returns. The fact is that the investing vs. gambling debate has less to do with the game you’re playing and more to do with how you’re playing the game.

Ironically enough, most skilled poker players hedge their risk better than the majority of investors. A skilled poker player will roughly calculate the odds of each hand, have a good read on his / her opponent, know their returns versus what they stand to lose, and fold a hand they know they are losing. That’s more than can be said of the majority of investors. Investors have a habit of placing trades on a hunch, without actually doing a complete analysis (risk/return, stock fundamentals, macroeconomic variables, industry analysis, etc…). I will return to the concept of investors making hasty, ill-advised decisions a little later on in this article. First, I would like to dig into the ever-popular topic of diversification.

The offense “Investors” are most often guilty of is lack of diversification. This is a recurring theme in Jackass Investing. As mentioned by the author, spreading your investments across a series of equities is not true diversification. During “angry environments” (a.k.a. extreme bearish periods), the diversification benefits from this strategy are abysmal. Those stocks that you thought would be a great bear market hedge will probably tank along with the market. That is exactly what we do not want to see. The charts below demonstrate that the effects of diversification are more apparent in extreme bull markets rather than extreme bear markets.

Click to enlarge

I am reminded of a well-known quote by the celebrated author Mark Twain: “A banker is somebody who lends you an umbrella when it is sunny and takes it away when it rains.” In this case, the banker represents diversification with equities. It hands you an umbrella on a sunny day by chipping away at your profits in a bull market, and takes that same umbrella away when it rains by failing to provide proper downside protection in a bear market. The whole point of diversification is to reduce losses in periods of instability. If diversifying with equities does not reduce downside risk, then it is not doing its job.

Many successful investors have actually spoken out against implementing a fully diversified portfolio, the most famous being Warren Buffett. To borrow a quote from Mr. Buffett: “Diversification is only required when investors do not understand what they are doing.” It has been said that Buffett, on average, diversifies his multi-billion dollar portfolio with only 33 stocks. In fact, Buffett has actually argued that concentration rather than diversification reduces risk.

My take on this situation is that Buffett, being one of the greatest financial minds of our time, does not need diversification. He analyzes his investments in such a thorough and rational manner that his probability of failure is minimal. Why should he bother hedging himself against a position he is so sure of? If he is correct 4 out of every 5 times, the gains on the first 4 positions will more than offset his losses on the 5th. The average, even savvy, investor could not possibly be so sure of their investments to the extent that they are above the need to diversify.

Now, I will return to the concept introduced in the first paragraph of investors making hasty, ill-advised decisions. Dever refers to these folk as emotionally charged “white-collar” gamblers. They have a tendency to buy into a stock when it has peaked and sell a stock when it is at rock bottom. One of the reasons for this is that they often react impulsively to one tidbit of information, without considering the bigger picture. Such white collar gamblers will often see that a stock has been on the rise for a period of time, and think it will rise higher due to increased investor sediment. Since they fail to do any further fundamental or technical analysis, they do not realize the stock has peaked; they buy it, only to be extremely disappointed when it drops 10% in the next month.

I have already given a strategy for creating a diversified international portfolio in a prior article called How to Remove Familiarity Bias from your Portfolio. For this article, I would like to introduce the concept of top-down investing, if you are not already familiar with it. A top-down investment strategy has three general tiers: economic analysis, industry analysis, and fundamental / stock analysis. The idea is to first select an economy, then select an industry, then select a stock or several stocks from that industry.

A top-down strategy begins with an economic analysis, which helps determine a suitable economy for investment. Some important considerations are as follows: GDP and currency trend analysis (has the GDP / currency increased or decreased in value each year for the last five years?); political risks (have there been any significant instability / corruption / uprisings in recent history?); market efficiency (is there one or more major stock markets in the country that have high liquidity?).

The next step is an industry analysis, which will narrow down one or more profitable industries within the economy selected in step one. Anybody familiar with CFA material will have heard of Porter’s five forces. The five forces are:

1) Entry barriers / threat of new entrants – we want this to be high because more competition=less profit for existing firms;

2) Threat of substitute products – we want this to be lower because the introduction of substitute products will steal revenues from existing firms;

3) Bargaining power of buyers/customers – we want this to be low because if customers have bargaining power, they can negotiate prices and steal profits from the firms;

4) Bargaining power of suppliers – we also want this to be low because if suppliers have the bargaining power to raise the costs of supplies, it will lower profits for the firms;

5) Rivalry among existing competitors – again, we want this to be low as competition reduces profit for everybody.

When analyzing industries, it is also important to consider the business cycle. If the economy is booming, you will want to choose a more risky cyclical industry, such as automotives. On the contrary, if the market has been declining with signals pointing to a possible recession, you may want to select a defensive industry, such as consumer staples; you may even want to short sell a cyclical stock, depending on how much risk you are willing to take.

After choosing the industry, the next step is fundamental analysis. This will help you select a stock from the industry you have chosen. Some fundamental factors I like to consider include: Operating margin (operating income / revenue)– you want to select a company that derives most of its revenue from its operating activities because this will be more sustainable; cash / share – you want to select a company that has enough cash flow flexibility to survive a rainy day; quick ratio ([current assets-inventory]/current liability) – you want to see a high quick ratio as it implies short term solvency; 5 year growth of net income – companies that have continually shown increasing profit are likely to increase, or at least maintain, their current share price; futures prospects – there really is no formula to follow here, but I recommend looking at new products / strategies that the company is undertaking and if/how they will expand in the future. There are many, many more fundamental statistics and ratios you can examine, but I think the ones above are a good start.

I would like to conclude with a quick demonstration of how the top-down approach can be applied. To demonstrate, I will use the example of A.O. Smith (AOS), a manufacturer of water heating equipment that I recently wrote an article about.

Economic Analysis: A.O. Smith operates in the U.S. economy and has strong international presence. While many are pessimistic on the U.S. economy, there have been some recent bright spots. September saw U.S. unemployment decrease for the first time since April, and the 2.5% third quarter GDP growth rate is nearly twice the Q2 GDP growth. These could be signs of a market recovery. Furthermore, A.O. has significant exposure to the Chinese and Indian markets, which are both strong emerging markets.

Industry Analysis: According to A.O.’s estimates, the North American tankless water heater industry should grow about 10% per year for the next few years. A.O. is currently the leading water heater manufacturer in the U.S., controlling approximately a 40% market share. The Chinese water heater industry, which A.O. has had an increasing presence, is expected to grow significantly in the near future as well.

Fundamental Analysis: A.O. has delivered a 21% growth in continued operations since 2008. Its cash flow per share of 1.56 is fifth best in the building products industry. In 2010, A.O. increased its sales in the Chinese market by 30% over the previous year, and plans to increase production in China by 50% in the next two years. Lastly, its recent acquisition of Lochinvar Group (a reputable water heater producer) is expected to add significant synergies and increase EPS by an estimated $.40 to $.50 by 2012.

Fundamental analysis is just one of the ways to make sure you are investing and not gambling. The book revolves around developing uncorrelated trading strategies that benefit from different return drivers. Through the use of these strategies, investors can lower their total portfolio volatility and enhance returns. Visit our website for a complete list of the articles in this series.

Source: Use This Strategy To Avoid 'Gambling' In The Stock Market

Additional disclosure: This series has been written on a contracted basis with the book's author. The opinions expressed in the article are those of Efficient Alpha and not necessarily those of the book's author. Efficient Alpha has been contracted to describe strategies and concepts used within the book but not to promote or recommend any strategies, the author, or the author's services.