What is the Assignment?
Jim Cramer has a homework rule taken from one of his books. It lays out some minimal requirements quite clearly. The most important is that doing the homework may require as much as one hour per week per position. Cramer quite correctly points out that using a buy-and-hold strategy on growth stocks will not work:
I can assure you that you will be soundly beaten by professional managers with good track records who are actively searching for good stocks all of the time.
This is excellent advice, but probably ignored by most of his readers.
The Intelligence Trap
In most endeavors intelligence is an asset. Here is the problem. Intelligent people are likely to believe that success in their chosen profession means that they will also be successful as investors. They read the Wall Street Journal and Fortune and a few other publications. Some of them also do online research, checking out the leading websites and blogs.
A little knowledge can be a dangerous thing....
It is possible to learn just enough to get into trouble. Most of my investors can discuss any current market issue for a few minutes at a cocktail party. Put another way, they have very good knowledge of information that everyone else already knows, information already printed in the paper and reflected in market prices.
There are some wonderful tools available to facilitate stock screening and back-testing of systems. Television advertising assures the investor that this is easy to do. The ads target investors who have some "dogs" in their accounts, evidence that their investment advisor was a clueless bozo! Since there will always be a wide range of account results, there is always a market for this type of appeal.
Powerful tools are great for users who understand both the subject matter and research methods. Those requirements would eliminate nearly all individual investors.
Here are two very simple illustrations. These are chosen because in each case there is only one obvious error. Doing research with more parameters increases the chance for error quite dramatically.
The yield seeker: A few years ago a friend who was a small client expressed an interest in income from dividends. For his own reasons, he wanted to own stocks, and he had read some articles that emphasized the importance of dividends. He went to a popular stock screening tool, entered a couple of requirements, and soon had a list of the highest-yielding stocks with acceptable market cap and liquidity. He sent us the list for our consideration.
What do you suppose that we found? It was a list of companies which were about to cut their dividends! Nearly all had some problem with earnings, debt, or both, so the dividend was in peril.
The pro with a system: Back in the "bubble era" we had dramatically changed our investment style, reflecting the market risk we perceived. One Saturday we read with interest a column in a prominent weekly financial publication. A professional manager, highlighted in a feature article, had described a group of laggard stocks that one could safely sell short against an aggressive growth portfolio.
We were amused to see two of our own holdings on the list of laggard stocks. What was the problem? These were both asset plays! In one case, we were waiting for real estate and timber to come into favor (which it soon did). The companies involved looked like laggards on a P/E basis, but only if one failed to look at the asset holdings. The person developing the system did not carefully consider all of the relevant variables.
And that was a professional! It was someone deemed worthy of a feature article.
We used the list to see if there was anything else worth buying!
Doing homework requires a commitment of time and a lot of specialized knowledge.
Future articles will examine whether popular investment sites help the investor get the homework in on time.