Where Are Those Winners Hiding?

  • Posted by
  • on May 28th, 2011

Via Indexed HT Ritholtz

As I got more deeply involved in markets, I wanted to quantify stock attributes in order to filter out the ones I didn’t want to study.  This started with fundamentals like growth rates and debt ratios and PEG ratios, and gradually moved towards pure liquidity and price analysis.  I’ve made attempts at using fundamental screens to narrow the field, but the business condition of big winners ranges from miracle turnarounds to revolutionary companies so that just hasn’t made sense.

So fundamental study for me is entirely qualitative and case by case, after I’ve narrowed the field quantitatively by price behavior.  I realize most folks do things the other way around, but unlike with price action I haven’t found commonalities strong enough to exclude companies by what’s on their income statement.  I think this amazing summary from Benchmark Capital partner Bill Gurley explains why; I’ll share the following excerpt:

“What drives true equity value? Those of us with a fondness for finance will argue until we are blue in the face that discounted cash flows (DCF) are the true drivers of value for any financial asset, companies included. The problem is that it is nearly impossible to predict with any accuracy what the long-term cash flows are for a given company; especially a company that is young or that might be using an innovative and new business model.”

I couldn’t agree more, both with the value of delivering cash flows and the difficulty of forecasting them.  His post encompasses EVERYTHING including why $GOOG is lagging, so I encourage you to read his first.  But for my limited brain to find tomorrow’s winners, I face the following choice:

1) Screen using some fundamental attributes common to past winners

2) Screen using price data that, by default, has no choice but to include those stocks being rewarded for showing superior traits

Both methods will result in a ton of false positives, stocks that have good fundamental or technical characteristics but fail to produce a continuation of those patterns.  But only the second method ensures that no company with traits of superior growth as described in Gurley’s post can pass through undetected.  OK, it’s possible a company with those characteristics gets acquired without ever having attracted the eye of growth investors, but when is the last time you saw that happen?  (Caveat…deep value investing is a different animal with a proven record of performance but it’s more about patiently waiting for balance sheet assets to be extracted.  I think keeping a list of favorites from value experts and joining when price confirms is a winner as well.)

The bottom line is that what we know is a miniscule fraction of what we can’t know.  Peter Lynch made Fidelity Magellan a monster partly because consumer stocks were in vogue but also because he understood the power of the attributes described by Gurley.  But local to national stories that we can “know” can be huge but are also rare.  Better to acknowledge how little we really know and use the only real evidence we have(price) to at least get the real gamechangers on our watchlist when market corrections take everything down.  I can’t possibly compete with industry experts on fundamentals but I at least have a fighting chance to follow their lead before the elephants decide to pile in.  These stocks don’t hide; they’re the ones we “missed” because they went up too fast.  Anyone besides me guilty of looking past the obvious more than once?

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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