Embracing the Dynamic Nature of Investment Analysis
November 22, 2020
The biggest thing I’ve changed about my investing process, and what I believe has directly led to a marked improvement in my investment returns, is that I am no longer filtering my investment choices through a single metric. When I first started investing, I was constantly looking for that one magical answer that could lead to market-beating returns.
This elusive silver bullet took many different forms during my early days of investing. When I first began, reasoning that if I simply filled my portfolio with stocks offering yields of 7% to 8%, any capital gains on top of that would be gravy, I looked for the stocks with the highest dividend yields. What I didn’t realize yet was that stocks with high dividend yields were usually the result of a drop in price from bad news or even from being in a perpetually declining industry. For many of these stocks, dividend cuts were just around the corner and, even if slashes to the dividend weren’t coming, stock-price losses almost assuredly were.
After my infatuation with dividend yields ended, I began looking for companies with low P/E ratios. After all, I reasoned, over the long-term value outperformed growth, so what could be better than buying the cheapest stocks on the market? All this accomplished was to lead me into positions that were more value traps than value. A value trap is a stock that appears to be cheap but is not because of deteriorating business conditions. This could mean anything from a pharmaceutical company with valuable patents set to expire soon, or tech stocks that are being disrupted.
My search for that elusive silver bullet continued until I realized investing was a dynamic skill with constantly changing conditions. Different metrics go in and out of favor regularly with investors; some simple (e.g. P/E ratios), some complex (e.g. Rule of 40). My investing processes and results both markedly improved after I shook off my tunnel vision while looking for one single metric and started incorporating a more holistic approach that looked at a variety of factors when investing.
Much more rewarding are great companies with durable economic moats, competitive advantages in their respective industries. Determining a company’s competitive advantage involves much more than just looking at a single number or formula. It involves reading through company transcripts and SEC filings and building a working understanding of different industries. But the end reward is worth it, allowing you to identify great companies that have dominant positions – or, better still, building a dominant position – in their respective industries. When evaluated correctly, these dominant positions can last for years, even decades, and will help investors tune out the short-term noise and tune into the long-term story.