A Leg Up on the Market

The Little Guy Can Win in the Market A Leg Up On the Market: The Little Guy Can Well Manage It, But It Takes Work by Benjamin J. Stein, in Barron’s Dec 11, 1989 One of the smartest people I have ever met, a true genius in several fields, including economics and mathematics, believes in the theory of efficient markets. That is, he thinks that all opportunities for gain based upon known facts already have been discounted into the price of stocks. Based on that conviction, he believes that he coul
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  The Little Guy Can Win in the Market Studying/Teaching/Investing Page 1 A Leg Up On the Market: The Little Guy Can Well Manage It, But It Takes Work  by Benjamin J.Stein, in Barron  ’s Dec 11, 1989One of the smartest people I have ever met, a true genius in several fields, including economicsand mathematics, believes in the theory of efficient markets . That is, he thinks that allopportunities for gain based upon known facts already  have been discounted into the price ofstocks. Based on that conviction, he believes that he could do just as well by throwing a dart atthe stock page as he could by doing research himself and buying according to what he foundout. Therefore, he buys more or less at random, ad makes a good return when the market ishot, a poor one when it is not, and overall about duplicates what he would make on bank CDs.Another friend, also extremely intelligent, believes that the security analysts and mutual fundmangers of major brokers and dealers already know about as much as can be known aboutstocks. Their research abilities and staffs dwarf her own, and therefore, she believes, there is nopoint in her attempting to study stocks and market. Instead, she buys shares in mutual funds.Some have done well. Others have done poorly. Over time, her holdings just about track — orslightly underperform--the Dow.Still another friend, who had apparently been following modern management closely, believesthe stock markets are rigged, that top managers will simply steal all good opportunities, and thatthere is no point in being in equities. He makes a steady, safe, small return in CDs at largebanks.Then, there is my friend George. He is also a smart fellow. But he believes that the efficientmarket is a vague concept indeed. If the market functions to liquidate inefficiencies, 1 hewants to be a part of that process. He studies 10-Ks, annual reports, magazines andnewspapers, speeches by CEOs. He snoops in legal filing and sometimes visits company sites.From owning investments worth thousands of dollars when I first met him, he has gone to aportfolio of tens of millions today, 15 years later.I know other Georges, too. These people are like little beavers, chewing through data atlibraries, reading reports instead of watching Cosby (The Cosby TV show), attending annual meetings instead of boating. These folks’ investments all seem to make out far better than the Dow, over time, and far, far better than CDs.Then there is little me. I have been speculating, albeit on a tiny scale, since 1958, when I was13. Over that period, I have observed that the one variable that predicts gains better than anyother is the amount of time I have spent researching the company. Where it is high, gains havebeen high. Where it is low, gains have been low or else there have been losses.Then there is what I have learned from my endless research into management buyouts. Theunerring result of my study has been that management or others with the same degree ofknowledge as management, make out extremely well on stock transactions involving 1   Another way to view market inefficiencies is through the eyes of risk arbitrage. Price will eventually move to intrinsic value; the gap will beeventually closed by the market.  The Little Guy Can Win in the Market Studying/Teaching/Investing Page 2 managements ’ companies. Persons who know less than management, or rely on the opinions ofsecurity analysts, do far less well. From all this, a conclusion leaps out: Even in the age of “machine - generated research,” as Michael Milken calls it, even in the age of legions of analyst and instantaneous trades of hugesize, it is still extremely worthwhile for individuals to do at least most of their own research.Here are the reasons why, as far as I can discover, anyone with any substantial capital, even oftens of thousands of dollars, is well-advised to do his own  research. First, Milton Friedman’s brilliant theory of personal gain says that if an individual is directly and substantially at risk, he will work far harder, far more effectively, than will anyone workingindirectly on his behalf. No security analyst in a lair on Broad Street can possibly be as motivated to pick stocks correctly as you are when your retirement or your daughter’s wedding expenses are on the line.Moreover, while many security analysts are undoubtedly well-trained and competent, as agroup, they tend to be wildly overworked. They have responsibility for a huge number of stocks,by and large. They simply lack the time to spend significant effort on any one stock. Failing tohave that time, they tend to rely on management estimates. Moreover, they often have agendasdictated by their employers. An analyst at even the best brokerage house might be influencedby the amount of inventory of a stock held by his firm, by the wish of another customer to sell,by the need to raise the market before a sale of new securities, or by any one of a number offactors.The individual investor, on the other hand, can pick a small universe of stocks and concentrateon them. He can read everything on the file about say, 10 companies, and get to know themextremely well. Any truly motivated intelligent investor can get to know a stock as well as anysecurities analyst and usually better. (I was consistently amazed, when I started my work onmanagement buyouts, to find that, when I discussed price with analysts, they were learning fromme, freely conceding that they just did not have time to do in depth research about many of thecompanies they followed.)The individual investor, moreover, need not worry about whether his picks will upset hisunderwriting department or raise eyebrows at the next staff meeting. He need not attempt togenerate sales for the sake of commissions. He need only worry about making money.In terms of motivation, absence of conflicting interest, and availability of time, almost allintelligent investors can surpass all but the very best, most energetic securities analysts.Second, the individual investor can if he wishes, use the accumulated knowledge of a lifetime toaugment his study of stocks — which most analysts cannot do. For example, a civil servant whoregulated advertising for the Federal Trade commission can form an opinion of whichadvertising agency has the best executives, responds fastest, seems to executives to have thebest management systems. To make stock picks, he can add to that what he reads in balancesheets. No inside information is involved here, but amount of knowledge that no analyst canhope to match.  The Little Guy Can Win in the Market Studying/Teaching/Investing Page 3 A farmer can use his knowledge of food processing; plus some SEC filings, to determine whichof these companies are well- run and which aren’t.  And on and on it goes. My friend George is in the entertainment business. His knowledge of ithas led to buys of Capital Cities, Warner, Viacom and others that have turned out to bespectacular investments.As for myself, I have an abiding interest in California real estate. Over the past 10 years, I haveconsistently been able to find stocks with market prices far lower than their asset values.Analysts consistent ly refuse to see these companies’ real value, even when they go intoliquidation so that the real-estate value can be quickly gotten out. This has provided a chance tobuy Southern California real estate in the 1980s at 1960 ’s prices .In my small case, I actually took time to visit some of the real estate in question, researchcomparable land values, and even hire appraisers (who usually could not get over that I wantedthem to tell me the right price and not vice versa). A result of this work was the discovery oflarge inefficiencies in the pricing of these stocks. As these were rationalized, the stock pricesrose, liquidating dividends were paid, and the inefficiencies were somewhat removed. But in theprocess, I made gains beyond those offered by any stock s on which I have not lavishedresearch time. To be sure, we are talking about tiny magnitudes, but nonetheless about largepercentages change. The point is that adding in one’s own knowledge and experience to additional resea rch yieldsworthwhile returns. The analyst in NY, usually wrong, usually without first-hand observation andexperience, cannot match the acumen the retired accountant can wield.And speaking of that, retired accountants can often capitalize on the best knowledge base of all.They usually have specialized background in one of two industries, know what is real and what isn’t, what works and what doesn’t, far beyond the scope of the securities analyst. Moreover, their knowledge of accounting allows them to read the indispensable heart of data about anystock, the balance sheet and its vital accompanying notes. To be able to do this with fluency is amajor plus in research. It would shock many people to know how few analysts can do this, orcare to do it, or have time to do it, with skill and in detail.Third and closely related to the very fact of an invest or’s removal from lower Manhattan, theindividual investor need not be moved by the fads and fancies of Wall Street. Unlike the peoplewho run together at the Downtown Athletic Club and have lunch at the City Midday Club, heneed not be swayed by rumors, gossip and fashion.The individual investor can work methodically communing only with fact--a major plus.Nor are the tools of analysis difficult to learn. Modest facility with arithmetic, the willingness toremember detail, the energy to compare and contrast, the same skills that make for success inany analytical enterprise, these are what it takes to study companies.Definitely, some knowledge of where extraordinary profits come from — price-fixing, monopolycontrol of markets (another form of price-fixing), and government granted monopolies (ditto) isvery valuable. Some idea of what concepts are just selling propositions without real world  The Little Guy Can Win in the Market Studying/Teaching/Investing Page 4 meaning is also valuable, but you can be sure that a few decades of life tell you that better thanany number of years of business school.I have never known an intelligent man or woman who tried to master the tools of companyanalysis and failed do so. There are no arcane formulas, no magic tests learned only on thebanks of the River Charles. Stock picking always comes down to common sense, and thatusually comes down to a few analytical tools and a lot of work and experience. Well, someone will say, but aren’t all managements corrupt? Don’t they lie? How can I ever  make a buck in that world?The answer is that the actively corrupt managers about whom I write often are still (I hope) theexception. The great mass of managers have all the foibles of other humans, but are notpurposely working to harm their shareholders. They still tell the investor enough to give a goodhead start on learning what the company is about whether there is inefficiency worthinvestigating. Don’t dwell on management to tell you everything, but management can start you in the rightdirection.Yet another person might argue: “Well, you may say all of this, but who are you to cite your few miserable examples and say this describes anything useful in opposition to the brilliantlyworked-out theory of the efficient market?”  The answer is, in many ways, the most telling of all. First, the most successful stock buyer in thepostwar era, Warren Buffett, says that he personally loves and worships the efficient marketth eory (“EMT”) . As he has often remarked, that theory so cripples and charms other investors,his potential competitors, that he has a far clearer field to pick his stocks, find hugeinefficiencies, and make billions. The EMT, in his view, is unilateral disarmament by mostinvestors. It allows the aggressive investor who does not buy into it to find bargains and makemoney, unhindered by others trying to do the same. Major gurus like Peter Lynch and my old pal Fred Alger (“Go -Go Money Manager from the late1960s) say the same thing. The EMT is really an alibi for those who would rather watch footballon TV. It is simply not believed, and with good reason, by the Larry Tisches, the WarrenBuffetts, the Mario Gabellis, who make the big dollars in stocks.Second, even if you do believe that markets discount every available piece of data that stillleaves plenty of room for individual initiative.After all, the EMT does not say that markets become efficient by extraterrestrial means,Individual human beings must read data, compare them with other data, and either buy or sellaccordingly. That is, some man or woman must take information and translate it into a price.Why should that person not by you?Someone has to see that the $10 stock is worth $20 and start the move up to $20 by buying inat a slight advance in price. Even such a minuscule speculator as yours truly has done it with
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