Insider series: the value of stock market research, part II

We continue yesterday’s discussion on the value of stock market research with Preet from Where Does All My Money Go (”WDAMMG”) and Brad from Triaging My Way to Financial Success (”Nurseb911) and myself (”TMW”). Today, we discuss topics such as what type of research is necessary for the do it yourself investor (again, this another lengthy post- clocking in over 1,900 words so be warned!)

RESEARCH AND THE RETAIL INVESTOR

TMW: Let’s address the second tension of independent stock research. Most retail investors are value shoppers and most DIYers want to rely on their own research. How do you, Brad, address the pushback from the retail investor?

Nurseb911: A lot of the time you get what you pay for; equity analysis and research is no different. If DIY investors want a discount analysis I can easily provide one. What they have to realize though is that I am not going to waste my time conducting research or an analysis on any business if I’m not compensated in some form for my work. Yes I am an author and enjoy publishing content on my website, but my time is worth something and if they’ve read my content for long enough they realize the effort and time that goes into what I publish.

In my private consulting I charge small business owners and individual investors a $75 per hour flat fee. When an investor considers they are receiving a SAML with a minimum of fifteen hours of work in it the retail price of $20 per report seems like a bargain to a lot of people and I’ve priced this program to be on par with the commission to buy or sell the individual stock.

The SAML program provides an inclusive stock analysis tool that I’ve already publicly published on my website (see Taking Stock in IGM). A fee only advisor would not provide this level of independent research or likely have the capabilities of providing one.

A DIY investor needs to think like the management of a successful company. You have to be proactive in your assessment of an investment instead of being reactive? Recognizing a fundamental shift in operations prior to it being announced publicly can save you a lot of money.

I would like to add that each analysis I’ve written has been chosen by a reader and currently I have a poll on my site for the next analysis: a Canadian Bank stock.

TMW: Preet- let’s look at this from the institutional side- is there sufficient push back from the institutions to not have independent research or do you think the industry says “yes, this is important that there is independent research and that the research is compensated properly”?

WDAMMG: I never found push back from access to independent research at all. In fact, speaking from my own experience, we had portals to third party research on our terminals from various sources: Credit Suisse, Reuters analyst aggregations, etc. Many advisors even paid for their own third party research through various research vendors. But this can partly go back to Brad’s comments on groupthink, or what Warren Buffett calls the institutional imperative. A lot of it looks the same, and how much easier does it become to push a stock when you have not one, but five different research reports to back you up?

TMW: So what you are really telling me is that institutions love research- as long as it helps them make a sale?

WDAMMG: Absolutely. From a compliance perspective, it can help cover an advisor’s butt too if investment recommendation and suitability is ever called into question – you have concrete support on the research indicating the relative volatility and other factors in writing.

TMW: From my perspective, I would divide the raging DIY and retail investor communities. The DIYers, many of whom are bloggers or commentators, probably have a better handle on the company than the analysts do since they are “normal people” and not subject to glass tower syndrome which Brad alluded to. I once joked on another blog that personal finance bloggers should form the government given that they write so extensively about money. The push back from the DIY crowd may have more of a “anything you can do, I can do better” theme which is great- with all due respect to both of you- since it should that people are actively interested in educating themselves about what they want to do with their money.

The retail crowd push back I would characterize as part of the trend of the financial industry to pretend that everything is free but the true cost is hidden somewhere else. As a result, we are conditioned to pay for nothing upfront. It is one of the more dangerous trends in financial institutions- telling your investors everything is free. The investor fails to see the input to output relationship. You have to input something (quality research, due diligence etc.) to get a positive output (good ROI).

KEY FACTORS IN RESEARCHING STOCKS

TMW: If a DIY wants to conduct their own research, what top three things should they be looking at as a basis for their decision making?

Nurseb911: An investor should always start with financial statements and the annual reports for the past three years at a minimum. While I understand the frustrations that many new investors have with analyzing financial statements you can’t do a proper assessment of a company without looking at them. These are the systems of what makes a company healthy and are no different than any physiological system within our own bodies. This is where you get a very good idea of what the company is about, what it does and any important trends that are occurring: are earnings rising, is book value declining, is the company growing sustainably, etc. Once an investor has an understanding of the overall business they need to concentrate on what makes a business successful: its products, services and people. If the business is something they understand, feel comfortable about and want to continue to pursue then there are three important fundamentals they should look for.

The first is profit; never invest in a company that isn’t making money. If a company isn’t making money they have to either borrow money to keep operating or burn cash/assets to continue operating. Take the time to examine the cost structure of the business, calculate their margins, compare them to industry peers and look for a competitive advantage if one exists. If the company isn’t making money put it on your watchlist. You might miss some upside as the company turns around, but you won’t be placing your capital at risk in a company that continues to decline.

The second is investor return; what you get paid back for investing your capital. Dividends count, but book value growth and return on equity (ROE) are vital components to evaluate. If a company isn’t growing revenue I want to ensure that management is being productive with their assets and increasing the value of the portion of the company I own. My capital is worth a lot to me and if I invest in a company I want to know that my capital is appreciating or that I’m being paid for the use of my capital (dividends).

The third is how the investment fits into your overall portfolio; does it help you to diversify from risk, sector exposure or another important component. Far too often an investor will choose an investment that doesn’t provide any meaningful diversification and exposes them to additional risks. Risk is what kills your returns. Investing is a balance between risk and reward, but an investor always has to be mindful of preserving their capital. If a company doesn’t fit into your portfolio don’t make it fit.

TMW: Preet- anything to add to this?

WDMMG: Not really, I’ll get on my soapbox instead:

There’s one free lunch when it comes to investing – you can reduce non-systematic risk by increasing the number of securities in your portfolio. Most studies peg 20 to 30 stocks as the minimum number required to effectively reduce non-systematic risk. Non-professional investors rarely have time to keep on top of 20 to 30 companies so I have to point out that a DIY investor with fewer positions than that is adding an element of risk to their portfolio that they may not be adequately compensated for. The relative return for that non-systematic risk may not be worth it, but it can also pay off for you (this is why many extraordinarily successful investors had concentrated portfolios, but many more investors with concentrated portfolios had extraordinarily poor results) – the problem is that if it works you can fool yourself into thinking that you have skill when all you had was luck.

TMW: This is more of personal opinion than anything else, but do you find most investors do not do enough research before buying. Preet?

WDAMMG: Not even close. If you are going to be buying individual stocks you should have the frame of mind of a business owner looking to take complete ownership of a business. If you wouldn’t be happy owning 100% of that business, why would you be happy owning 0.1% of it? And if you were going to buy a business, wouldn’t you spend weeks to open up the books, analyze your competitors, etc, and be prepared for a very long term commitment if you did decide to purchase? If you can’t comfortably decipher the financial statements, stop kidding yourself – you’re not an investor, you’re a gambler.

Brad?

Nurseb911: Absolutely.

I think if an investor can’t address the previous three items I listed regarding what to look for as the basis of their investing decision then they should have a clear answer of whether or not they’ve conducted enough research.

ETF’s and index funds are great products to invest in while an investor learns how to analyze individual stocks. My entire portfolio was indexed prior to starting to invest in equities and it gave me a great opportunity to practice portfolio rebalancing, dollar cost averaging and other important habits of investing. If you don’t have the adequate discipline to invest before you begin investing in equities what makes an investor think they can develop it on the run? Investing in individual companies brings a lot more risk than many investors realized prior to this current market decline. The rewards can be significantly higher, but also are the risks.

Far too often an investor rushes into a stock without having adequately done the research needed to understand the business. That might take 5 hours for you and 15 for me, but the important lesson is that we both understand our investment.

TMW: I tend to agree with both of you. The point being do not abdicate your responsibility to anyone. Only delegate it. Preet- your opportunity to give a shameless plug. What are you up to?

WDAMMG: For those who don’t know, I moved on from being a retail financial advisor to the institutional and retail sell-side with an index fund manufacturer. It’s a “me too, margin compression business” so it’s not without it’s challenges, but with a lean staff to keep costs down it means I get to wear a lot of different hats. But probably more interesting to the readers is that I completely embarrassed myself by auditioning for a TV hosting gig with the W Network. They had asked for audition tapes from anyone from any field of discipline. It started as an online contest with 400 submissions being whittled down to 20, and then those 20 reduced further to 7. The final 7, myself included, filmed for two weeks in March for three 30-minutes TV episodes to be aired on the W Network on June 21, 28^th and July 5^th (all Sundays, primetime, tentative) to declare an “Ultimate Expert”. Wish me luck! J

TMW: Good luck Preet. I’ll vote early and often if there is a chance. Thanks guys. Hope to do this again another time.