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Blog Post: A Novice Investors Thoughts on Individual Stock Selection

J. Falatko

Those close to me know that I have entered the cliché fraternity of doctors that dabble in the stock market. My venture started three years ago. I have learned many lessons. It’s actually made me a far better physician. There has been a lot of growing pains. In this post I will share some of my experience. *

I have spent a good portion of my life studying medicine. I considered medicine the most complex topic one could study. That was until I discovered finance. There is great discovery in medicine. There are problems being solved at a breakneck pace. However, the human body is governed by physical laws and boundaries that can be identified and manipulated. Financial markets, not so much. The intellectual power being devoted to solving markets is greater than anything I have witnessed. Analytics, statistics, forecasting models, behavioral finance, artificial intelligence are just some of the areas of intense innovation. The intellectual power isn’t just in the US. The brightest minds in other countries are working on this problem as well. They are all playing the game on the stock, commodity, and bond exchanges around the world. The object is to transfer the most wealth from others to yourself. The competition is fierce. Since I am on my own, I know I am significantly outmatched.

Despite all this effort, there appears to be only relative winners and losers. The scale of winners and losers is not evenly distributed. The winners follow a power law distribution, while the rest of us either blow up, or settle somewhere near where we started. But there has been no absolute winner, which makes this endeavor so enthralling.

There appears to be more to investing than just growing wealth. Its competitive. Which is why it attracts so many participants. It provides feedback, comparison to others, and distinguishes winners from losers. Whenever an individual creates a successful strategy it slowly seeps through the market. The success is then slowly eroded by the spread of said information, since it is no longer scarce. Prices are bid up until buyers are exhausted and the strategy stagnates. Did the creator of the strategy find something truly unique, or was the success simply random chance? Either way, if he or she keeps their success a secret the gains are dampened, since no one else knows about it. If the creator is a good salesman, and they sell it well to the right class of people, momentum builds, and the power law kicks in.

Warren Buffett is the man most people associate with the stock market. He spread his knowledge piecemeal through his annual letters and gathered an army of followers. His name alone can bump a stock 5% when he takes a position. This is a true winner. Does he really know something others don’t, or does he sell it well? This is the great chicken or the egg mystery of markets.

I have read several books on investing. The most important book I read before I got started was A Random Walk Down Wall Street by Burton Malkiel. It was so important because it taught me about assets. The different categories. Their historical returns. How they may or may not correlate with one another. It was a great description of the battlefield. Can you believe I didn’t know what a stock was when I graduated college? I paid $100,000 dollars for that education.

One of my favorite authors is N.N. Taleb. I’m a little afraid to mention his name for fear I misrepresent his work and this post somehow makes it to him. He is one of the most vicious intellectuals on twitter and one of my favorite follows. His books Fooled by Randomness and The Black Swan taught me so much. In his books he talks about the platonic fold. It is this gap between what you think you know and what you actually know. The less you recognize the gap, the more likely you are to blow up. He discusses the significant impact of very rare events. How a few moments in time change a person’s life forever. But his most important edict, in my opinion, is survival. Warren Buffett is “Warren Buffett” for the simple fact that he survived in the market for 7 decades, while everyone else before him either died or blew up. To succeed you must first survive. The market rewards survival.

My favorite book on individual stock selection has been Peter Theil’s book Zero to One. It should really be named Zero to 100 Billion. Peter Theil is the founder of PayPal and a very successful venture capitalist. You may recognize his name as one of the first investors in Facebook. In his book he describes the characteristics of modern companies that lead to accelerated growth. Particularly those characteristics that grow by power law and not on a linear scale. If you can detect these in a business before the herd, there may be a great opportunity. Superior technology, network effects, economies of scale, and brand recognition are some of the most important topics he discusses.

I have tried many different strategies over the past three years attempting to follow in the footsteps of others. I’ve traded options. I’ve hedged positions. I’ve shorted some stocks. Purchased commodities and emerging market bonds just to name a few. I’ve read so much and researched so many different trading techniques. I’ve had some winners and plenty of losers. That’s mainly because they were outside my scope of knowledge, or I sold them because I lacked self-control. I don’t know much about options and how they are priced, so I’ve been burned several times. I’m not a farmer, so I know nothing about hogs and corn. I don’t understand anything about oil, and OPEC. I don’t understand gold, or why anyone would want to own it. It’s used to make jewelry that’s the depth of my understanding. Will we ever have a situation in society in which we are going to exchange gold for goods and services? I don’t think so. Same concept for bitcoin. There are so many options, and it’s easy to get distracted.

On the individual stock selection level there are all these factors like momentum, value, growth, deep value, dividend aristocrats, dividend growth, etc. These factors lead to more distractions. They are based on underlying metrics like price to book, price to earnings, discounted cash flow, trading volumes, golden crosses, etc. The number of algorithms that could be generated by all this data is infinite. Some of them are going to be right by sheer chance. Making some fool rich thinking they’re a genius. The best explanation I have heard about factor investing comes from the history of the metrics used to follow them.

The story goes as follows. After the great depression investors in the stock market were very risk averse. So, they valued tangible assets like real-estate and equipment. Wealth that could be easily measured. This is a company’s “book-value.” Stock price/book value was the most important metric. This became oversaturated and irrelevant as the decades passed and investors cared less about tangible assets and more about reliable earnings as a sign of safety. So, low price/earnings outperformed, but this became oversaturated and today is likely irrelevant. Throughout the 70’s-80’s interest rates were very high, so stocks had to compete with bonds as an asset class by raising dividends. Investors wanted reliable income. Dividend growers with reliable earnings were the most popular. When interest rates started declining stocks gained in popularity in the 80’s. Investors realized that the market was forward-looking. Companies were no longer priced for what they were worth in the present, but the future. Predicting the future with accuracy was key. Discounted cash flow models became popular. Too many institutions learned how to do it, so the information edge waned (even though they are still used today, I don’t think any value remains). After the crash of 2000 price to earnings gained in popularity again as fear heightened, but this did not last very long. With the emergence of companies like Amazon and Google in the early 2000’s a better predictor of future growth was return on invested capital. This is the first time that having some imagination became valuable because by the time the return on the capital was known, the money had already been made. This has evolved today to accelerated revenue growth and total addressable market (TAM). Honestly, today it is all about TAM. What will the market care most about in 2020-2030? That is the question you have to get right before anyone else.

Jeremy Grantham said it best, “Low price to book are the assets Wall Street cares about the least, low price to earnings are the earnings Wall Street is the least impressed by, and high dividend yields are the yields Wall Street trusts the least.” Factors and metrics may be moving targets. They are only successful because the majority believes in them. When sentiment changes, they become obsolete leaving a few outposts swimming in misery.

Most of the people reading this likely have a retirement account or a financial planner that constructed a simple portfolio for them of various index funds. For anyone that does not find this stuff interesting, or pays little attention, the 60/40 (stocks:bonds) portfolio of index funds is probably the smart thing to do. You will survive. This wasn’t enough for me. I wanted in on the game. So, to summarize there are a couple principles I have learned so far. I hope I continue to learn more.

1) You want to own companies that are moving away from bankruptcy, and avoid companies that are moving towards it. Easier said than done. Believe it or not companies like Intel and BP are moving closer to bankruptcy than away from it.

2) Only place bets on your best ideas. Don’t waste opportunity on “wims”, “weak logic”, “stock tips” from your neighbor, and diversification for the sake of diversification. The casino beats you by tricking you to play many hands with the odds against you. “Diversification is a protection against ignorance. It makes very little sense for those that know what they’re doing.” -Warren Buffett

3) Envy will ruin you. One of my favorite quotes comes from Charlie Munger, “Envy is a really stupid sin because it’s the only one you could never possibly have any fun at. There’s a lot of pain and no fun. Why would you want to get on that trolly?”

4) Prepare your mind for battle with itself. Practice self-control. You should say no 10 times as often as you yes.

5) Don’t put yourself in a position to go broke. There’s a thousand different ways to blow up. No one forces you into complex trades that will put your account to zero. No one forces you to use leverage, or go on margin. You do it to yourself. So, don’t. You’ll only end up broke and divorced. Survival is key.

I hope to add more to this in the coming years. That’s all the knowledge I have to impart for now.

*Some of these ideas were poached from those much smarter than myself. I will give credit to those I can recall. If you read this, and I quoted or misquoted you, I apologize.

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