Período Umm an-Nar

Back in the world of more mainstream investment advice, many invest-ment writers such as Jim Cramer concentrate much of their content on the topic of research and hammer home that the investor needs to do extensive research into any stock he or she proposes to buy. Most of these books advise the reader to scrutinize the annual report, quarterly reports, and 10k reports filed by the company. They go into exhaustive detail explaining how the balance sheet and income statement of a company

work. They then apply the information gained from the balance sheet and income statement to obtain ratios that will give a picture of how the stock price level relates to elements taken from those financial statements, such as price/cash flow ratios, or price/book value ratios. Some investing advice books suggest that the prospective investor should talk to the senior management of the company or listen into conference calls given by the company’s management to discuss quarterly earnings. Such a privilege used to be reserved for the financial analyst community, but in more recent times, it has been theoretically opened up to all-comers.

In his former life as a commercial banker, including stints working in credit analysis departments, coauthor Aidan McNamara was trained to work with balance sheets and income statements. This enabled him to fig-ure out whether the company to which the bank intended to lend money had the financial strength and cash flow to repay those loans. One half of the couple writing this book is therefore literate in financial statements.

Nevertheless, we do not agree that the financial information that the annual or quarterly reports or 10k filings impart have any real urgent relevance to either the individual long-term investor or to the short-term trader who is using our approach to trading. Why?

The Average Joe is simply not going to learn anything new from these statements. There are hundreds, and sometimes thousands of equity ana-lysts on both the sell-side (those working for the investment banks and bro-kerage houses who distribute securities to investors), and on the buy-side (those who do proprietary research for institutional investors—pension funds, mutual funds and the like), all engaged in crunching every last num-ber released by the company. They parse endlessly comments made by management and seek to make buy, sell, or hold decisions based on every strand of available information all day, every day. It is ludicrous to suggest that a private individual, picking up and reading the annual report when he has a spare moment, will possibly glean some additional insight from an obscure footnote somewhere in the text that everyone else has missed. It is na¨ıve to expect the average person can home in on some nugget of price-moving information from the balance sheet or income statement that the research professionals have not already noticed. Yet this is precisely what many investing books recommend that their readers do, claiming that the investor will gain an edge by making the effort to carry out precisely this kind of research.

It may be counterintuitive, and sound to some like heresy, but it is our belief that there is not a lot of point in either the long-term investor or the short-term trader immersing himself in the minutiae of the com-pany’s business and financial reporting because all that information is al-ready reflected in the stock price. This is especially true as far as the larger well-established companies are concerned. Please note, however, that this

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view by no means puts us in the camp of the Efficient Market Hypothesis (EMH) brigade.

The EMH was first theorized in the 1960s by Eugene Fama, an eco-nomics professor at the University of Chicago nominated for the Nobel Prize. The hypothesis posits that all important financial information about a particular company is already factored into the current stock price. The EMH is often combined with the Random Walk Theory. This theory states that stocks follow a “random walk” meaning that the movement of stock prices does not follow any kind of pattern; prices are simply “random.”

Thus, even by looking at past movements, it is impossible to predict how a stock will perform in the future. Combining the EMH and Random Walk Theory one can conclude that it is impossible to beat the market.

Yet this is clearly not the case. The EMH and Random Walk Theory are wrong because time and again some very bright people have managed to beat the market well and consistently. With all due modesty, we claim this for ourselves. As we have made clear above, we share the view with EMH theorists and with Dow Theorists (see Chapter 3) that all financial, eco-nomic and political factors that could affect a stock price are factored in, including all that research on the company done by professional analysts.

On the other hand, however, where the EMH and Random Walk theorists have it wrong is in their discounting the effects of fear and greed on both the overall market and the prices of the individual stocks within it. We be-lieve that the principal drivers of market and individual stock movements are the raw human emotions of fear and greed. However much a stock price may reflect all relevant financial information, and be pushed higher and lower based on new information that comes into the public domain, it is the conflicting emotions of fear and greed of millions of investors (both professional and lay), that in the end are the predominant factors moving prices of individual stocks and of the overall market. It is by understanding the nature of these human emotions, and taking advantage of the irrational actions they often cause investors to take, that the short-term trader can make money using a contrarian approach, while essentially disregarding most of the torrent of financial information that is generated on each com-pany and its stock every day.

This is not to say that we believe the investor/trader should have no interest in learning about the company in which he is taking an investment or trading position. On the contrary, as we set out in Chapter 4, a very important element in our trading strategy, and one we believe to be of fun-damental importance to long-term investors too, is the principle of “know your stock.” Being knowledgeable about the company you are investing in or trading; its business, what it does, makes and sells, and to whom—all this is grist to the mill of a successful investing or short-term trading strat-egy such as ours. This information is available from daily use of companies’

products, reading the business and financial press, watching financially ori-ented programming on TV, keeping up-to-date generally on trends in the economy, industry and the specific corner of the market in which the com-pany operates. It involves essentially keeping your eyes open. However, what it does not mean is trying to divulge from the company’s financial statements nuggets of financial information that will give you “an edge”

over other investors/traders. You will not find anything there that is not al-ready in the stock price. Remember too that a company’s reported financial statements are based on historical cost accounting. Also, they represent a best efforts attempt to provide a snapshot of where the company is today financially, not where it is going. Both investors and (to a lesser extent) traders are looking to the future when they put their money into a com-pany and the idea that the financial statements provide the backing for the investment/trading decision seems to us like trying to drive while firmly fo-cused on what is going on in the rearview mirror. Remember that our com-ments here apply specifically to the lay investor attempting to take the raw financial data and working out investment decisions based on it, something that is a standard piece of advice in investment advice literature. Insights provided by professional analysts can be helpful in getting an up-to-date all-round feel for what is going on at a company, often without the selec-tivity of more “newsy” aspects that is the tendency of financial journalism.

If your online broker offers research, and all invariably do, then find one or two research companies that you can access that way and use these to round out your knowledge of companies that you are monitoring or con-sidering for purchase. Our own favorite is the Argus Research Company, whose research is available free online to clients of Charles Schwab &

Co. Again we emphasize that the purpose of using this research is to round out knowledge on your target companies, while not getting bogged down in the nitty-gritty of financial ratios and other arcane information that the research also sets out for you. One exception to this is an insight into the company’s cash position and net debt position. Research houses such as Argus will always point out those companies that have a particularly strong cash position, and as we point out in Chapter 5 this can be a useful piece of information to assist in a buying decision.

A theoretical exception to our argument that detailed knowledge of the financial information of a company provides no particular edge to the individual investor or trader is exhibited in the advantage that company insiders may have, at least in theory, when it comes to trading stocks in the market. Corporate insiders are defined as a company’s officers and directors, and any beneficial owners of more than 10 percent of a class of the company’s stock. Such stockholders are obliged to file with the Securities and Exchange Commission (SEC) a statement of ownership and to report their insider transactions within two days of the date the

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transactions occurred. It is illegal for such insiders to trade when they are in possession of material information that is still not public. Insider information gives those who possess it such a tremendous advantage to profit from big moves in a company’s stock price that acting on such information is deemed so unfair as to be illegal. Once information is in the public domain, however, and the company’s stock price has moved in ac-cordance with the news’ positive or negative implications, the information has no additional value—it is already reflected in the stock price.

THE COST OF TRADING: IT’S NOT AS BAD