The Problem With Shortcuts
The movements of the markets often seem chaotic and perhaps that’s the reason why so many people are obsessed with the idea of finding one key metric that will tell them if a company is a good investment or not. In fact, it’s actually one of the most frequently asked questions that we get in here at MyWallSt:
“If you guys were to pick one metric to look at in a company, what would it be?”
“How much importance do you put on the P/E ratio?”
“What are the rules you use for valuations?”
I completely understand where these people are coming from. Wouldn’t it be fantastic if there was just one thing you could look for in a company to identify a winner? Surely the attributes of stocks that have been wildly successful in the past can be codified into a simple formula? Why hasn’t someone done that yet?
Published in 1949, ‘The Intelligent Investor’ by Benjamin Graham is still regarded as the bible of value investing. Graham himself was a wildly successful investor over the course of his life and many of his concepts, including the ‘Mr. Market’ allegory, are still used by investors today.
As a value investor, Graham was also a big proponent of using formulas to assess potential investments. The ‘Graham Number’, for example, was a way in which he estimated a stock’s fundamental value by using the earnings-per-share and book-value figures. Or what about his instruction to buy stocks that were trading for less than their net working assets, or all of their cash and other assets minus their debt.
This sounds like the perfect solution — clear guidelines from a market-beating genius on how to find great stocks. However, as noted in Morgan Housel’s fantastic new book ‘The Psychology of Money’: (emphasis is mine)
The formulas presented in the book were appealing to me because they were literally step-by-step instructions on how to get rich. Just follow the instructions. It seemed so easy. But something becomes clear when you try applying some of these formulas: few of them actually work.
So what’s the deal? Is Graham a fraud? Is Housel using the formulas wrong?
Let’s take another extract, this time from Graham himself:
I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook was first published. But the situation has changed a great deal since then.
Change is constant, and nowhere is this more profound than the market.
There have been many innovative ways to assess companies over the years, but the problem is that these only remain relevant for a very short period of time. As Housel notes, Graham’s formulas might have worked when he first published his book, but the fact that he had to release several updated editions of ‘The Intelligent Investor’ proves that there is a limited lifespan for formulas. As the market moves on and industries rotate in and out of importance, the strategies once used to find great picks no longer work.
Price-to-earnings (P/E) ratio is a good example of a metric that has lost its relevance over recent years. If a company doesn’t have earnings (i.e., if it's not profitable), it doesn’t have a P/E ratio. Imagine how many fantastic investments you would have missed out upon over the past two decades if you unflinchingly stuck to that method of analysis. Amazon famously didn’t turn a profit for years when it first started out.
Everyone can (and should) look back at the big market successes to date and figure out the attributes that led to these companies’ fortunes. However, the stock market is a forward-looking machine and the success of companies today is not so much based on what has happened in the past but rather what we expect to happen in the next day, week, month, or year.
Moreover, picking great stocks takes time. It takes looking at companies from a quantitative and qualitative point of view, it takes a lot of research and reading. It takes going with your gut sometimes and, more times, it requires taking losses on the chin and moving on to the next one.
As much as we might wish that there was one key metric or secret formula to picking winners, there are no shortcuts in the stock market. However, those times do happen to land upon one of those big winners that eclipses your losses many times over, you’ll know the journey was totally worth it.