Most investors rely on stock tips because it is the easiest way to get into the stock market without doing much work or requiring much effort.
They will pick up comments like this, “I think Hongkong Land is very undervalued right now given the situation in Hong Kong,” especially from someone who they believe is a good investor. Even if it wasn’t meant to be a stock tip, it might be taken as one by the eager investors.
There are no shortage of ‘stock tips’ if one is actively looking for them. The sources include, but are not limited to, friends, the media, blogs and online forums.
We have not known anyone who has built wealth by following stock tips.
There would be a few good calls but these are often outweighed by many bad ones such that you cannot depend on tips to achieve a sustainable long term return – if it was so easy, more people would be far richer.
Another common source of stock ideas is to invest in the companies you do business with.
It could be a supplier used by your company, or a restaurant you patronise, or a brand of computer you always buy. While it indicates some demand for the company’s products or services, one cannot assume that the business is doing well.
It is okay to generate trade ideas from these sources but an investor must be able to evaluate the stock independently and not blindly follow whatever someone said or simply invest in a business you enjoy patronising.
Even the famous fund manager, Peter Lynch, said this;
“I don’t advise you to buy stock in your favorite store just because you like shopping in the store, nor should you buy stock in a manufacturer because it makes your favorite product or a restaurant because you like the food. Liking a store, a product, or a restaurant is a good reason to get interested in a company and put it on your research list, but it’s not enough of a reason to own the stock! Never invest in any company before you’ve done the homework on the company’s earnings prospects, financial condition, competitive position, plans for expansion, and so forth.”Peter Lynch
But the problem doesn’t end here.
Even if you are a diligent investor who does your homework and research, you might still encounter a deeper problem known as confirmation bias.
Psychologists have found that we decide first and justify later.
Hearing a stock that we like or focusing on the company we always patronise suggest some form of favouritism. Even if you conduct research, you might unknowingly seek out the good about the companies while ignoring the bad. This is because you have decided to buy the stock and you are doing ‘research’ to justify why you should buy it.
If you have spent a lot of time researching about the stock, it becomes harder not to buy it. The endowment effect creeps in and you end up with a very biased way of investing.
If you keep generating trade ideas through these ways, you will always end up with more or less the same stocks you are exposed to or are familiar with. There’s a high chance that the stocks with the best opportunities are not the stocks you know. An investor is rewarded by his ability to act on a good opportunity and not a stock you like.
This is how we generate stock ideas
Given the problems above, there’s a reason why we prefer to be blind to the stock names. They create too many biases. We cast our net wider to all the stocks listed in the exchange.
For example, there are about 750 stocks listed on the SGX. Most people will only know the top 30. There are actually more opportunities in the remaining 720 stocks. But we won’t know all the stocks well so this is where a stock screener comes in handy.
The next hurdle is to know what to screen to reduce the number of stocks to a manageable level.
Each person has his favourite metrics as well. Some prefer high ROE while others may prefer high dividend yields. Usually, each investor uses a combination of metrics to screen.
Our cautionary advice is that many metrics don’t really make a difference in investment returns. You might be using placebos without knowing that.
This is why we strongly encourage you to leverage on Factor Investing to choose the core metrics to screen stocks for. There are tons of research in the past 25 years on what metrics work and what don’t.
You don’t need to test with your own money. The PhDs and Nobel Laurette have done it for you.
For example, low Price-to-Book ratio is a core metric for deep value investors and it has proven to work for over the past 80 years and counting.
It would be a good starting metric to use to screen for undervalued stocks.
The lesson is this: if you don’t like to put nonsense in your mouth, you shouldn’t anyhow use metrics without the proof that they can give you higher returns.
Our screen results typically end up with about 40-60 stocks. This is where we do some ranking and start analysing the stocks in more detail.
Few investors are as quantitative as us.
Most are qualitative or I call it story-driven investing.
We are definitely more numbers-driven. There are pros and cons and Warren Buffett puts it well in one of his annual letters to shareholders of Berkshire Hathaway,
Buy the right company (with the right prospects, inherent industry conditions, management, etc.) and the price will take care of itself.” On the other hand, the quantitative spokesman would say, “Buy at the right price and the company (and stock) will take care of itself.” As is so often the pleasant result in the securities world, money can be made with either approach. And, of course, any analyst combines the two to some extent—his classification in either school would depend on the relative weight he assigns to the various factors and not to his consideration of one group of factors to the exclusion of the other group. Interestingly enough, although I consider myself to be primarily in the quantitative school (and as I write this no one has come back from recess—I may be the only one left in the class), the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a “high-probability insight.” This is what causes the cash register to really sing. However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side—the figures should hit you over the head with a baseball bat. So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.Warren Buffett
We are 70% quantitative and 30% qualitative.
We know it is very easy to get astray with great investing stories because we are easily attracted to them and have so many biases that sabotage our decision making. Our brains are not designed for investing. They are wired to fight or flight during danger.
Thus, it is easier for a beginner to be more quantitative as it requires little experience or insight to do well. In this case, Factor Investing methodology is a godsend.
Qualitative investing should be reserved for master investors who are very well aware of their biases and can use the experience to overcome their default biological circuitry.
Gut reactions are usually very wrong or very right. They tend to be wrong when they are based purely on emotion and in domains where you lack experience. They tend to be right when they are rooted in deep understanding and well-developed taste. Trust your gut when you have the experience to back it up.James Clear
Our concern is that many investors think they are at the master level and heavily use qualitative analysis and stories to buy stocks.
There’s definitely a good dose of overconfidence bias thinking they can invest like Warren Buffett.
We hear and see this a lot among investors. Buffett is a curse if you don’t have the experience to back it up. Qualitative analysis coupled with a concentrated portfolio will spell disasters for overconfident investors.
We don’t think we are at the master level and hence we are still largely quantitative investors with Factors as the cornerstone of our investment approach.