Robert C. Merton is perhaps one of the most brilliant financial theorists in the world. He received the Alfred Nobel Memorial Prize in Economic Sciences in 1997 for a new method to determine the value of derivatives, Merton's research focuses on finance theory, including life-cycle finance, optimal intertemporal portfolio selection, capital asset pricing, pricing of options, risky corporate debt, loan guarantees, and other complex derivative securities. No doubt, he is an incredibly brilliant man, but at the same time, he was the principal of Long-Term Capital Management, a speculative hedge fund that collapsed in the late 1990s after losing $4.6 billion. Not only was he extremely smart, but all 15 of his partners were super smart too.
Long-Term Capital Management did business with nearly everyone important on Wall Street. Indeed, much of LTCM's capital was composed of funds from the same financial professionals it traded with. After its collapse on September 23, 1998, Goldman Sachs (NYSE:GS), AIG (NYSE:AIG) and Berkshire Hathaway (NYSE:BRK.B) offered to buy out the fund's partners for $250 million, to inject $3.75 billion, and to operate LTCM within Goldman's own trading division. The offer was stunningly low to LTCM's partners, because at the start of the year their firm had been worth $4.7 billion. Warren Buffett gave Meriwether less than one hour to accept the deal; the time period lapsed before a deal could be worked out.
Unfortunately similar to the case of Robert C. Merton and LTCM, the stock market is full of smart people and companies doing stupid things ... the list is long: Jeff Skilling of Enron, Bernard Madoff, AIG, Lehman Brothers, Fannie Mae, Freddie Mac, and so on.
As Warren Buffett mentioned in this great speech -- what is important are the qualitative factors of a person, because everyone has the intelligence to do just the right thing.
When asked about Long-Term Capital Management just 4 weeks after the final call to agree on the bailout, Warren Buffett recounted one of the most valuable lessons I have ever heard in financial advice:
"... if you take John Meriwether, Eric Rosenfeld, Larry Hilibrand, Greg Hawkins, Victor Haghani, and the Nobel prize winner Myron Scholes. If you take the 16 of them, they probably have the highest average IQ of any 16 people working together in one business in the country,including Microsoft or whoever you want to name--so incredible is the amount of intellect in that room. Now if you combine that with the fact that those 16 have had extensive experience in the field in which they operate. I mean, this is not a bunch of guys who made their money selling men's clothing and all of the sudden went to the security business or anything. They had, in aggregate, probably 350 or 400 years of experience doing exactly what they were doing. And then you throw in the third factor: that most of them had virtually all of their very substantial net worth in the business. They have their own money tied up, hundreds of hundred of millions of dollars of their own money tied up, a super high intellect, they were working in a field they knew, and they went broke. And that to me is absolutely fascinating. If I write a book, it's going to be called "Why do smart people do dumb things?
To make the money they didn't have and they didn't need, they risked what they did have and did need--that's foolish, that's just plain foolish. If you risk something that is important to you for something that is unimportant to you, it just does not make any sense. I don't care whether the odds are 100 to 1 that you succeed, or 1,000 to 1 that you succeed. If you hand me a gun with a thousand chambers or a million chambers, and there is a bullet in one chamber and you said 'put it to your temple and pull it' , I'm not going to pull it. You can name any sum you want. It doesn't do anything for me on the upside, and I think the downsize is fairly clear. I'm not interested in that kind of a game, and yet people do it financially without thinking about it very much. It's like Henry Kauffman said the other day -- the people going broke in these situations are just two types: the ones who know nothing, and the ones who know everything."
Just listen to these words of wisdom from Warren himself, and if you have time, check the full series of 10 videos. There is too much knowledge there.
So what does it take to succeed in financial markets? I bet being smart is definitely not the most important factor -- just don't do stupid things! If you are a man or woman of principles, and you don't do dumb things financially, you will succeed. Investing is not rocket science. Everything can be learned, and you can put your money to productive use.
I love Ted Williams' sentence from his book, "The Science of Hitting," one of Buffett's favorites: "I have said that a good hitter can hit a pitch that is over the plate, three times better than a great hitter with a questionable ball in a tough spot." In other words, yes! Just avoid doing stupid things. You can even beat professionals, sometimes, just because they are so smart, and they are much more willing to take more risk ... but most of the time with disastrous consequences.
So if you want to invest and you are not so smart, just follow these simple rules, and I guarantee in the long run you will do just fine:
Never Buy High
The stock market NEVER travels in one direction, what goes up goes down. So why do you have to buy when prices are high? It doesn't make any sense financially. Yes, it is true that sometimes people believe stocks can go up indefinitely because they have been doing so for years, even for a decade--like in late 80's and all of the 90's. But I don't need to tell you what happened after that, in 2000. At some point, sooner or later, bubbles explode, even if they can hold it for years. Just think about it. In 2000, the PE ratio of the S&P 500 was 43, and today it is 15.8. In other words, if you invested in a S&P 500 index fund in 2000, you may have to wait 43 years just to get your investment back, which is a completely irrational valuation. The PE ratio of Coca Cola (NYSE:KO) in 2000 was 88, and today it is 19. If you had bought Coca Cola at that valuation, and sold it 10 years later, you would have made -18% in your investment. Your chance to make a good profit when PE ratios are irrationally high is pretty small. Robert Shiller in his magnificent book Irrational Exuberance had a great self-explanatory graph of how PE ratios correlate with returns after 20 years. Not surprisingly, whenever you buy low, in 20 years you do much better than when you buy high. As you can see, the highest returns have been when PE ratios are below 10.
When interest is low, go and buy stocks. When interest is high, get out.
Although it is not always true, in general, interest rates play an important role in the price of securities. If the market is down, (bear market) the central bank drops the interest rates, so fixed income investments became unattractive, and people move back to the stock market. If the opposite occurs, (bull markets are high) the central bank intervenes, increasing the interest rates in order to make alternative investments attractive, and cools off the heat in the market. In May, 2000, when the stock market was at an all-time high, the prime rate was 9.5%. Now it is 3.25%. So, interest rates can give you a hint as to whether it is the right moment to invest in stocks.
If you are not an expert in the stock market and want to do well, a safe approach is to buy large caps that pay dividends. These companies are usually very solid, and their stock is less volatile than other small or medium cap stocks. You won't become rich overnight, but by doing that, you add an extra layer of protection to your investment. Remember always that even though size and dividends are important, it is not a guarantee that those investments are safe havens. Look at Kodak, Circuit City, Clear Channel, Palm, and many others that have disappeared from the S&P 500 since 2002. In a study done by Innosight lead director Richard N. Foster, the average lifespan of an S&P 500 company in the 1960s was more than 60 years. That span narrowed to 25 years in 1980, and now the average company lifespan is a mere 16 years - a near 75 percent decline in the average lifespan in just 50 years. Sixteen years is a very short economically useful lifespan for businesses, and creates all kinds of implications for investors. This study implies that you will have to make many more portfolio changes than your parents or grandparents experienced. So the best tip I can give you here is to look for companies in which the market is expanding because of social economic or technological developments. ie: plastic money. Ten years from now physical money will be a rare thing, and most of the transactions will take place with cards or phones. The indisputable winners will be MasterCard (NYSE:MA), Visa (NYSE:V) and Amex (NYSE:AXP).
Focus on earnings not on sales
When the market is low, (bear market) everybody talks about earnings, but when the market is high, (bull market) everybody talks about growth and sales. Consider for example eToys, a firm established in 1997 to sell toys over the Internet. Shortly after its initial public offering in 1999, eToys' stock value was $8 billion, exceeding the $6 billion value of the long-established "brick and mortar" retailer Toys "R" Us. And yet in fiscal 1998, eToy's sales were $30 million, while the sales of Toys "R" Us (TOYS) were $11.2 billion, almost 400 times larger. And eToys' profits were negative $28.6 million, while the profits of Toys "R' Us were a positive $376 million. Despite these publicly aired doubts, investors loved eToys. But it didn't take long for the doubters to be proven right. eToys.com filed for bankruptcy and was delisted from the NASDAQ in March 2001. At that point, everybody was talking about growth and sales. Few people were paying attention to earnings. So if you start to read in the newspapers about great companies exploding in sales and users, but nothing about earnings, run for the exit. That's the first sign of a industry bubble. Does 600 million users sound familiar to you?
Pay attention to dividends.
When the stock is down, (bear market) suddenly companies start paying nice dividends. This is just because they need to incentive investors with some kind of extra income rather than just capital appreciation. When prices have been high relative to earnings, the return in terms of dividends has been low, and when prices have been low relative to earnings, the return in terms of dividends has been high. As a matter of historical fact, times when dividends have been low relative to stock prices have tended not to be followed by higher stock price increases in the subsequent five or ten years. Quite the contrary -- times of low dividends relative to stock prices in the stock market, as a whole, tend to be followed by price decreases over long periods, and so, returns have tended to take a double hit at such times, from both low dividend yields and price decreases. Thus, the simple wisdom-that when one is not getting much in dividends relative to the price one pays for stocks, it is not a good time to buy stocks - and, it turns out to be right historically.
One of the main reasons people don't realize that dividend-paying stocks do much better actually than not paying dividend stocks is because all the graphs from major financial sites just show the capital appreciation of the stock, but don't include the dividends there. So when someone is comparing historical data, the view is completely misleading. The only page I know where you can find total return graphs of a stock is ycharts.com. Here a quick example of a graph from Pepsi (NYSE:PEP) comparing just price stock increase (capital appreciation) vs stock increase plus dividends (Total Return), a 15.63% difference in just 5 years.
PepsiCo Stock byYCharts
Below is the return of dividend paying stocks vs non-payers according to ThomasPartners
Invest, don't trade.
If there is a nice job in this world, it is being an investor. When you invest right, you can generate passive income for years to come, without the extra work that requires physical office work, for instance. Just think about this -- Warren Buffett gets $408M per year in dividends just from Coca Cola . He owns 200M shares, and Coca Cola pays an annual dividend of $2.04. He doesn't really work for this money. The money just comes to him from financial decisions he made 24 years ago.
Buffett began buying shares of Coca-Cola in 1988, and soon had a sizeable position with millions of shares. This surprised some on Wall Street, especially since Coca-Cola stock had gained almost 20 percent a year for eight years, with many analysts thinking it was over-valued. But Buffett was not among them, and in fact, took the opposite view. Wall Street thought he was crazy. Yet Buffett had his own metrics. He saw Coca-Cola as a "cash cow" in 1988, a company with steady shareholder equity growth and an incredibly well-known brand, globally. Buffett believed he was buying Coke at a discount price, compared to a reasonable valuation of the company and its future prospects. Buffett began buying stock in Coca-Cola Company, eventually spending about $1B for seven percent of the company. By March 1989, Buffett's Berkshire held close to 22.35M shares of Coca-Cola, and today he owns 200M.
By the end of 1989, Coca Cola represented 35 percent of Berkshire common stock portfolio, while today represents 23.3%. It was a bold move. But with time, Coke would prove to be one of Berkshire's most lucrative investments, turning a $1 billion purchase into a $14.2B holding that generates 408M a year in dividends.
The only work Warren Buffett is doing with Coca Cola today is probably reading the quarterly and annual reports. That's a nice profit for few hours of reading every year.
Traders don't have this luxury. They have to work like crazy to make their numbers. They don't care about fundamentals or companies prospects. They just care about volumes, concentration, distribution, and a long series of different technical indicators that help them pull the buy or sell button. Besides being a very stressful and time consuming job, it has other disadvantages, such as greater taxes, more trading costs, and no income from dividends. So why worry about trading? Just buy good businesses when they are affordable, and let the money come in over time. Don't play the trading game. As Warren Buffett says: "Someone's sitting in the shade today because someone planted a tree a long time ago."
Follow The Leader
If you definitely don't have the time and inclination to make your own investment decisions, the easiest way to avoid mistakes is to follow the people who spend their time and resources making sure the decisions they make are the correct ones. This is something great that the new technology era facilitates to individual investors. Old investors like Benjamin Graham or Warren Buffett never had the luxury of finding information as easy as we can do it today with just a computer and Internet connection. There are great sites where you can see the holdings, purchases, and sales of major mutual funds. Of course, don't follow the risky ones. Some safe bets are Berkshire Hathaway, Sequoia Capital, Fairfax or Yacktman, all of them led by distinguished value investors such as Warren Buffett or Prem Watsa (the Warren Buffett of Canada). The sites you can use for your research are www.alphaclone.com, www.gurufocus.com or, just look for the prospectus of these funds and see what they hold, and do what they do. You will sleep well for years while you see your positions grow. Buy when they buy, and get out when they get out. At www.covestor.com you can also follow all kinds of investors, and every time they make a trade, the trade replicates automatically in your account. I'm one of the investors that you can follow there.
Finally -- be patient and don't be stupid!
Impatience and stupidity are the two worst enemies of good investors. If you are impatient, you can sell or buy at the worst time. It doesn't matter if you have thousands of dollars in the bank, if it is not the right time to get into the stock market, DON'T DO IT. Wait until things cool off and make the best use of your resources. Be patient. Nothing ever travels in one direction. Even the best company in the world has not done that. At some point, companies have hiccups that will provide you an excellent entry point level. Yes, it may take years, literally, but believe me it is worth the wait. And please don't do stupid things either. Leverage the risk through options and derivatives. It is not worth the risk. People start to play with that innocently, and then the ambition becomes greater and greater, and the next thing they know they are risking at a whole different level where there is no point of return. Just like the smart guys at Long Term Capital Management, stupidity can kill you in the stock market. Be savvy, do the right moves, and let time do the rest.
Follow all these simple rules and you will dramatically increase your odds of success in the stock market.