Deciding What Sort of Investor You Want to Be
Al Root has an article out now comparing what he feels are the three investment styles to planetary orbits. Do we want to be stuck on a single orbit though?
Al Root is a regular contributor to Barron’s, and in his latest article on their site, he looks to define what he believes are the three investment styles and compare them to planets orbiting around the sun. His three investment planets are value, growth, and trading, and we’re supposed to look within ourselves to decide which one of these we wish to go with.
Root tells us that this is the first step in becoming an investor, deciding which of these investment orbits we wish to travel on. We need to take a lot bigger step back than this though to begin.
This in itself makes some pretty big assumptions that we can benefit from looking at by doing our own study of investing astronomy. We need to start by looking to understand the planets that he sees, come up with some other ones if they become visible with the telescope we’ll be using, and also wonder whether we would not be better off choosing a planet that doesn’t see moving around the sun in a fixed orbit as the best idea or even a good one, and see what other approaches we may be able to come up with to tackle this issue.
The first thing we can look at here is the Trading planet, at least the one that Root is seeing, which is out there in the sky but really is not an investing planet at all, and therefore isn’t really an option that investors can choose, even though having this as a reference point in the sky may end up being helpful.
Root defines trading pretty narrowly in fact, involving trades of 6 months in duration or shorter, although there are those who call themselves traders who hold their trades for longer than this. While time frames do define trading, trading isn’t just defined by them and trading is best distinguished by being a process rather than something that one does over this or that period.
We can define trading more simply as seeking to stay in positions for the length of the current trend, which can be any length, even though it is true that a lot of traders do hold for much shorter periods of time than people we would call investors would. You can trade on any time frame, including using monthly bars, and these positions can be held for a lot longer than 6 months or even 6 years depending on the circumstances, mostly due to how the trade is performing.
People are trading the current 10-year bull market for instance, and may have not gotten a signal yet over this time, and what makes them a trader in this situation is that they have held all this time not based upon external data but based upon continued bullish price performance. The line has been pretty much straight up over this time, and while there are always wiggles, we can set different degrees of sensitivity to these wiggles such that we’re only trading the bigger moves and our system will filter out shorter-term moves such as what we’ve seen over this time on a monthly chart.
Someone else might be trading one-second bars and in a few minutes might be in and out of several trades. The length of time we’re in trades therefore depends on how sensitive our trading plan is, but the real lesson for investors is that we do not have to confine these techniques to the shorter stuff, and this can work on even a long-term horizon, where we expect to hold for many years but have an exit plan based upon price if it does go against us enough.
What really sets apart what we call trading from Root’s other two investing planets is that trading solely or at least very substantially is based upon price performance, looking at the stock in other words and not the company’s performance itself so much or usually not at all.
Traders, especially those who we call position traders who might be in a play for a year or two depending on performance, may also look at fundamentals for guidance, for instance an earnings report, but they will mostly look at how the market reacts to these things rather than how we may feel that they should. Should is a dangerous word in both trading and investing and we actually need to banish any such thoughts because when the market does one thing and we think it should do another, the market is always right because the market decides these things without any help or influence from us or anyone.
There are some qualities to trading that we may wish to use to shape our chosen orbit when we do choose one, but we do not want to necessarily just pick one of these three and go with that, because this will limit not only our thinking but our progress and ultimately our success. If there are elements of one of these approaches, or others we may discover that may help us, we don’t want to look away and miss out.
We Can’t Just Bark Up the Lesser Tree Without Looking at the Bigger One
The other two planets, the value one and the growth one, both get all of their data from looking at the company, and ignore both the climate and the performance of the actual things that we’re looking to decide on, the stocks or the indexes or what have you. Detaching ourselves from these things may not be a good idea though, because how the company does may be connected to its stock price to some degree, but nothing is more connected to a stock’s price than its price.
We can have three different companies with the same business performance, with one having a stock that is performing strongly, another doing poorly, and one in between the two. People on these two planets miss this entirely, it is not part of their planet’s reality, but it needs to be if they wish to do as well as they should.
Given these divergences in performance, they should be thinking that there must be more to this than just looking at near-term business performance and projections, and the answer here lies in the perspective that investors have, which is much longer out than this. Since this longer-term view is where the value is being derived from, this is not something we should be ignoring, even though you can do quite well often times by looking away from this.
In our example, the company that is outperforming the averages is at least perceived to have a brighter future, even though it is making the same return on investment as the other two stocks. The poorer performing company has a dimmer outlook than average, and we could call the third one the market, coming in right at average and the object of the affection of those who like to invest in indexes.
On the Growth planet, they like to focus on companies who are growing their earnings on an above average basis, which at least puts them on the right side of the ball since we are out for growth when we invest in stocks. This is still different from looking at how much growth the market is pricing in, which is something we can get by just comparing price to earnings ratios, where higher ratios can be seen as measuring the degree of future bullishness the stock is believed to have.
Beliefs here do create reality though, and if the increased company growth that growth investors hope for does manifest, this still all becomes expressed in these future stock price expectations to one degree or another, and we therefore still need to account for them if we really want to be riding fast horses.
In a sense, growth investors are picking strong looking horses, but if we want to see how fast they run, we can’t just look at the pedigree of their stables, we need to see how they do on the track. An oil company may be growing their earnings quite nicely over the last little while, but if their long-term outlook is more suspect, this just won’t translate to speed, and this is why they have lower ratios than the average stock.
Root has Peter Lynch sitting on the throne of the Growth planet, and Lynch truly is a legend and worthy of this crown. To get an idea of Lynch’s prowess in his prime, his wife put $3000 into an IRA in the mid 1970’s and turned it over to Peter to manage. We would not normally think such a paltry amount could be turned into a big nest egg, but they managed to pull out $3 million from this account over the years and when she passed away in 2014, they still had $8 million left.
What really makes this run impressive is that most of it was done when it was much tougher to do well, when the bears were a lot bigger than they are today, huge in fact, and the bulls were much smaller and slower.
That’s the power of growth in the right hands, even with its shortcomings. Lynch is widely considered to be the best growth investor of all time, and Root also brings up the name of Warren Buffett to sit on the throne on the value planet, another legend of course. Buffett has also done his share of amazing things, under even bigger constraints, but we need to be careful not to be comparing Babe Ruth and Ted Williams to help us decide whether we should be a home run hitter or singles hitter.
Lynch and his fellow growth investors win this battle pretty easily, not so much against Buffett who has competed fairly well over the years, but against the entirety of his legion. He beats Buffett as well though anyway, for what it’s worth, even though Buffett has famously defended the honor of his tribe extremely well. None of these results tell us what could have been, how many homers the Babe could have hit if he worked out a lot harder for instance, and this is a question we need to ask because it’s all about doing your best and not even settling for a hall-of-fame career when you could have been bigger and better.
We Need to Bring Back the Best of All These Worlds to Ours
Time has passed both of these legends by though, and neither are doing very well lately. They are both in advanced age now, and in an era where being more aggressive is the way to do and is amply rewarded, there relatively more conservative approaches just don’t work that well anymore. Lynch is long retired and just trades his own account these days and is struggling with that, where Buffett still sits at the head of the table of his company but he has been afraid to invest at a time where you could throw darts at stock boards and make a lot of money as long as you hit the board.
This might actually be a wiser approach than it may appear, and the reason is that he is so wedded to a strategy that has become very dated that he really isn’t seeing that many of these prime opportunities anymore. It’s better not to invest than to invest badly of course, and he’s already taken a big enough haircut from some of his current positions, especially with Kraft Heinz.
Value investors prefer the slowest of the three horses we’re looking at, the ones that have lower ratios and therefore have stocks with a dimmer future, and the dimness of this future is seen as a plus. As a general rule, it is not, although there are certain situations where if you can foresee the future brightening up, it may make sense to buy these stocks if the time is right and they actually are on the road to recovery and merely need to catch the pack. This is way beyond either the skills of your typical investor or your typical value fund manager. Everyone on this planet wants to be Warren, but there is only one Warren.
Investors on Planet Value therefore take on more risk, as there is a greater chance of being wrong when you are buying damaged merchandise. Some do turn into gems but their luster still may not measure up to the ones who have retained their shine, the growth stocks, and the chances of seeing goats behind this door are also higher, for obvious reasons, even though this escapes value investors for the most part.
In the days of Ancient Greece, sides in a battle would each choose a champion to fight it out head to head, with the losing army becoming enslaved, where we’d be looking for Lynch and Buffett to fight it out as our proxies. We don’t want to do that here though and it’s better to look at how these two armies measure up to one another to decide which one we want to join, if the choice is just between these two.
When we look at the situation from this perspective, the growth army clearly wins, even though this really isn’t a fair fight in terms of returns. The growth camp shoots for more company growth at least, and this type of growth is better correlated to a corresponding growth in asset prices than purely betting on underdogs yields.
The value camp, in modern times at least, also takes on more risk, not less, so they end up losing on both counts that matter. Risk management is a lot smaller of a deal with long-term investing though, as the idea is to ride out the dips on the way up the mountain, and a little bigger dip won’t matter as long as we continue to climb overall. If the top of the mountain is many years away, the journey may make for some interesting tales but it’s our destination that really matters.
We should want to account for the performance of the stock itself though, and while shooting for company growth is nice, we also need to be paying attention to the one thing that will ultimately determine our fates, which is the price movement of a stock over time.
Being a good growth stock in the traditional sense should matter, and we could even call this a necessary condition even though it isn’t the sufficient condition that people think it is. In order to understand this properly, we need to see both sides of the matter, how both the company is doing and is expected to do, and how the stock is doing and is expected to do.
We could call this new orbit the Performance planet, where we want both the company and the stock to perform. If we had to choose one or the other, we’d want to pick the performance of the stock to look at, but since we’re looking to invest longer-term, the company’s business outlook and growth trends should matter as well.
We may even want to look to spot some companies whose company results look good but the stock is left to struggle more than their business results would indicate, in situations where we have good reasons to believe that this will indeed turn around for them. What we need to realize though is that without major change, this isn’t likely to happen and comes in well below the level of confidence we need to invest wisely.
Making trading being one of our planets actually is appropriate, since we need to borrow from traders to manage the performance of the stock. We can use this to both confirm how well business growth is translating to price performance, measure future expectations by the market, and even use this to better spot pivot points where the mood of the market has turned in a way we can take advantage of which is not captured very well in price to earnings ratios, which may still be low as the move gets underway and builds more momentum.
We can actually say that there are four other planets in addition to this new one we want to create, with the fourth being called the Momentum planet, and it’s actually the one that anyone using a trading style to invest already lives on. They just look at stock prices on this planet though. We want momentum to be in our favor to be sure, both in terms of the price momentum of the stock and the business results of the company, and with both in tow, we then are giving ourselves permission to shoot for the stars.
This is not about what style of investor we may want to be, it’s about what kind we should be. Should therefore does have its place in investing after all, even though we don’t choose to use it in this context anywhere near enough. We cannot even hope to reach our investing potential unless we open our minds a lot more, and that’s the actual best starting point.
Editor, MarketReview.com
Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.
Contact Eric: eric@marketreview.com
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