“You have to earn the right to use a multiple” — simple, yet profound, words from investor Michael Mauboussin.
I learned this lesson the hard way. My first experience with “investing” — and I use quotes because what I was actually doing is an insult to real investors — was picking stocks based on a ratio I found on the internet.
Here’s how the “process” went:
Go to Yahoo Finance and look at how the P/E (price-to-earnings) of home-improvement retailers Home Depot
HD, +0.20%
compared with Lowe’s
LOW, +1.46%
• Buy the one with the lower ratio.
• Watch it all day, every day. Hope it goes up.
• Sell when I made/lost a fixed dollar amount.
• Rinse, repeat.
Read: The stock market often produces its strongest returns after yield curve inverts
Why did I start with fundamental analysis, and why did I think there was any meaning in a couple of ratios?
The first thing young investors find when they Google “best investing books” is Benjamin Graham’s “The Intelligent Investor.” I thought I learned something from his writings, but what I really discovered was how not to invest. I assumed that you could be successful by knowing only two pieces of data: price and earnings. I didn’t even earn the right to call myself a first-level thinker.
Most investors, certainly beginners, should stay away from thinking that ratios are a substitute for real analysis. It’s not that valuations don’t matter; of course they do. But, like Michael said, “You have to earn the right to use a multiple.”
Below are just a few questions I wish I knew to ask when I first started:
• What is the historical ratio for the industry?
• What is the ratio for the overall market?
• Is this company growing faster than the market? What about its peers?
• Where was the ratio six months ago, three years ago?
• Is the ratio going up because price is rising or because the denominator is falling?
• Does literally everybody else see this very public piece of data
• What do you know that they don’t?
In regard to that last, and arguably most important, question: During the conversation with Patrick O’Shaughnessy, Mauboussin asked: “If you’re buying, who is selling and why?”
I’ll tell you who: It’s people who have moved 3,000 miles past the price-to-earnings ratio: “The goal is to find patterns on the fuzzy edge of observability in financial markets, so faint that they haven’t already been exploited by other quants.”
Robin Wigglesworth wrote about these people at D.E. Shaw, a hedge fund that currently employs over 80 PhDs and 25 International Math Olympiad medal holders. They’re begging you to trade based on a ratio. They’re sharks. We’re shark bait.
It’s normal to look for shortcuts, but if you’re really trying to learn about a business, ratios are not a fundamental hack. Like Mauboussin said: “Multiples are not valuation. Multiples are shorthand for the valuation process.”
My journey started with the price-to-earnings ratio. It ended with me buying index funds. I’m lucky I learned at a young age, through trial and a lot of errors, that there is more to being a successful stock picker than comparing a stock’s price to the company’s earnings.
The O’Shaughnessy-Mauboussin podcast was great. Here’s the link.
Michael Batnick is the director of research at Ritholtz Wealth Management LLC. He’s the author of “Big Mistakes: The Best Investors and Their Worst Investments” (Bloomberg). Follow him on Twitter.
Source : MTV
