Trusting 'experts' can be a costly mistake
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Tim Bennett Jul 24, 2009
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Faced with today's uncertain economic outlook, investors might be tempted to look to the 'experts' – fund managers, newspaper tipsters and professional analysts – for guidance. But that could be a mistake.
1. Don't follow gurus
Warren Buffett is well known as a great investor – so why not just copy him? A London School of Economics study showed that, from 1976 to 2006, a portfolio that mimicked Berkshire Hathaway (his investment firm) at the start of each month after its purchases were publicly disclosed earned 10.75% a year above the return from the S&P 500.
But that doesn't mean the strategy will work for you, says Tim Hanson on Motley Fool. Berkshire is very different now compared with 30 years ago. Its huge size means it can only trade in very large stocks, suggesting future returns will be more pedestrian than in the days when Buffett had his pick of the small caps. And because of the "Buffett effect" – a boost to share prices when he buys – Buffett now tends to favour "private deals or full acquisitions". Neither route is open to retail investors.
Following gurus in general is a bad idea because you don't know why they're buying, says Hanson. A deal might be motivated by a desire to get on even terms with a rival buyer, or even by tax considerations. You just don't know. By all means "study Buffett's shareholder letters and apply those lessons to your investing" or invest in Berkshire if you want a piece of his success. But don't slavishly follow his – or anyone else's – share trades hoping to match his returns.
2. Don't follow the newspapers
A recent study by Lily Fang and Joel Peress for Insead business school ranked stocks by how often and how prominently they were mentioned over the decade ending 2002 in four US newspapers – The Wall Street Journal, The New York Times, The Washington Post and USA Today. They found that around 25% of stocks got no mentions at all, a few were mentioned "hundreds of times" and the average chalked up 12 mentions a year.
What's interesting, says Jack Hough in Smart Money, is that the 'no-media' stocks "clobbered high-media ones by three percentage points a year". The very best performers were "small companies with limited analyst coverage and plenty of individual (as opposed to institutional) coverage". Here the "no-media premium" hit 8-12% a year. The reason is simple. Stocks heavily covered in newspapers tend to be the most popular ones. So your chances of getting in early enough to grab a bargain – ahead of the big investment institutions – are slim.
3. Don't follow analysts either
Professional analysts are paid well to come up with share tips. So you'd think they'd be worth following. Not so, says David Dreman, author of Contrarian Investment Strategies: The Next Generation. He analysed 1,500 US stocks from 1971 to 1996 and found that analysts' top tips actually underperformed the market 75% of the time. Why?
Analysts set short-term price targets by taking future expected annual profits or cash flows for a company, then expressing them all in today's money using 'discounting', before adding them up. In short, if the 'target' value is higher than the current share price, it's a buy. Sounds easy, but there are big challenges.
One is predicting future profits or cash flows, and knowing how far ahead to look. Another is picking the right discount rate to turn those forecast annual returns into today's money (as £5 received as profit or rent in two years' time is worth less than £5 received now). Cut future returns by 10% rather than 5% a year, and you'll get a very different valuation. The higher a stock's risk, the higher the discount rate applied and vice versa. Another highly subjective number, called a stock 'beta', is used to capture this risk. Put it all together, and conjuring a share-price forecast is much more art than science.
What to do instead
Do your own research. "You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right," said Ben Graham, who analysed stocks using value investing ratios such as price/earnings rather than following 'gurus'.
You are also more likely to uncover bargains among less-well-known small-caps. One worth watching is Zytronic (LSE: ZYT), a little-known "world leader in what is evidently a fast-growing sector", says Tom Bulford, in the Penny Sleuth newsletter.
The firm's touchscreen technology for vending machines has just been adopted by Coca-Cola. The forward p/e is 15, the stock is covered by just two analysts, according to Bloomberg, and a search on Google news throws up no mainstream press articles. We'll be asking our experts for more small-cap ideas in next month's MoneyWeek Roundtable.
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