Passive investing, active investing, value investing, momentum investing, winging it …

Investment Perspective – June 2017

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price… the cash up value. What matters more is the economics of the business” 

Peter Flannery

For those who do not understand investing, once they start looking into it they discover that not only is there a mountain of material to work through (thank you internet!) but there is conflicting information.

So who do you believe?

I can make that easy for you.

If you want no control, have no concerns about the outcome of your investments, how much money you will make and prefer to adopt a defensive, totally hands off approach, then putting your money into low cost passive index pooled investments is likely the way to go.

If you like control over your investments, are happy to use advisors to let them do the heavy lifting for you and prefer to determine how much money you make at the end of the day, then I offer Value Investing as a suitable alternative.

There are a myriad of options in-between.

Perhaps the most common in the area of sharemarket investing would be momentum investing through sharebrokers.

The advantage of what they offer is that the information is publicly available and thoroughly analysed. We can pretty much rely on the information coming out of share broking houses as reliable information to use when we are investing. Generally, sharebrokers are an honest bunch. Pretty much we can trust them.

Reliable (which has merit) is one thing. Useful is another.

Perhaps the disadvantage of momentum investing is that it is based on a form of modern portfolio theory (diversify to manage risk) and investing in larger companies that have already grown.

More interesting is the reason they deal with large companies.

What is the reason?

If you asked them they will inevitably tell you that it is because they cannot make money out of analysing smaller companies because there isn’t enough scrip available for them to trade.

When companies are too thinly traded, it becomes more difficult to locate a buyer / seller which slows down and reduces the number of trades. That means less money for the share broker.

The bottom- line is that they make money by what we call “clipping the ticket” which just means that they take a brokerage whenever an investor buys and sells. They get paid when investors buy and sell. Hmmmm…

Looks Ok on the surface

In the short term that is actually not a bad approach and can be reasonably low cost, but that changes longer term. Momentum Investing is based on making lots of adjustments and changes to investments….buying and selling. That costs money and hurts investment performance longer term. There are a couple of other fundamental problems.

Firstly, they argue (in fact a certain share broker around Tauranga is very vocal about it) that you cannot beat the markets so why bother trying.

Well of course you cannot beat the market if you invest in a spread of large companies that basically mirror the market.

Whilst in the short term actually this is fine, in the longer term, the basis upon which those large companies are selected revolve around the financials rather than the underlying economics of the business.

So, they take a momentum driven approach, which means that they will hopefully get their investors in as things are rising.

The problem of course is when things stop rising and start declining what happens then?

The bottom-line is that this approach is very much based around the financials and the price of the actual stock.

It is challenging to know, particularly in the short term, which way is best. Short term pricing data tells us nothing about the fundamentals of neither a business nor whether it is a good investment long term.

In fact there are times when momentum investing over some phases of the market does perform quite well from a pricing perspective (which is what most novice investors focus on).

Indeed, when looking at Value Investing as a methodology and comparing it to momentum investing during bull markets, momentum investing actually looks better as does investing in passive index funds.

The markets’ fascination with price movement is as though price and value are t he same thing. This upward price movement can be very convincing for those unfamiliar with Value Investing.

I have lost count of the number of times I have heard my clients say (when they first come on board with WISEplanning) that, every time they invest in something they lose money because the price drops.

That is because they chase the hot stocks that are often promoted by share brokers who practice Momentum Investing. The challenge their clients face is the methodology (not the brokers!).

You are maturing nicely…

A number of you reading this will know that we have often joked about a certain conversation that I have with my clients from time to time. It goes something like this:

Peter Flannery: So how are we tracking with your portfolio do you think?

Client : There has been some ups and downs. The Rule of Five does seem to work and yes we are pretty happy with the way things are going.

Peter Flannery: That’s great and you know, you are coming along well too … You are maturing as investors quite well.

Client : Actually Peter, we were thinking that we are getting you trained up and that you are maturing quite nicely !!

In method we trust

Here is the winning strategy. It’s really simple. It’s called “stay the course ”.

The Value methodology at WISEplanning is based on investing in the business rather than playing the markets. We use financials to analyse the stock as it were, however we also look at the underlying economics of the business to establish whether or not to go there in the first place.

As you know, The Rule of Five applies and what we know is that investments chosen based on the financials and price movement along with market euphoria can work, but can also be purchased when they are expensive and therefore take a long time to make us any money as investors.

Buying good businesses on the other hand means that even if we pay too much and need to average down, long term, those businesses will be resilient and continue to grow.

They will help us as advisors and investors to know that investing in good businesses (productive assets) is a great way to protect your capital, manage risk and to grow your wealth long term, regardless of economic conditions.

With momentum investing and investing in low cost index funds, the money made from those investments, particularly in the short term, is more about price movement and economic direction.

Longer term though, good businesses not only protect our capital but give us some control over where we invest, how we invest and provide us with a real opportunity to grow and compound our investments longer term, without having to worry about whether or not they are good investments.

Investments are not good just because everyone likes them at the moment and the price rises fast.

Investments are good because of the underlying economics.

Investments selected on the basis of momentum investing may or may not have good economics.

Passive index funds have zero economics.

The price movement, particularly in the short term has little to do with it and serves as an entry or an exit point for Value Investors.

But why doesn’t everyone do it then?

Those with little understanding about investing often come up with the question, which is based around the idea that, if what we are doing is that clever, then why doesn’t everyone do it?

Other questions to ask are

• “Why do some doctors drink too much later in their careers? ”
• “Why do some professors of economics with doctorates in finance finish up poor?”
• “Why do people who want financial security not implement financial plans and position themselves for success?”

As Warren Buffett mentioned decades ago, he has seen no swing towards Value Investing. This appears to remains true today.

The simple key to investment success

Over many years, I have come to the conclusion that if we can understand the underlying economics of an investment, we can successfully narrow our portfolio, avoid other less effective methods and invest for growth, keeping our capital safe… regardless of economic conditions. Few investment methodologies can offer that.

On Wall Street (corporate America/investment bankers) pay:

“A man does not deserve huge amounts of pay for creating tiny spreads on huge amounts of money. Any idiot can do it. And, as a matter of fact, many idiots do do it.“

Charlie Munger