Last week, I published the third post in my Stock Picking series (see Parts I, II & III), and it got me thinking – I haven’t seen a good mystery/blind stock challenge in a long time! There’s obviously tonnes of great investing advice out there to harvest, but the lessons we really take to heart are those we learn via trial & error, and hard won experience…
As I’ve been banging on about, stock picking is really composed of two very distinct processes: Stock Valuation & Stock Selection. But investors often tend to confuse & conflate the two… Just like meeting a person for the first time, stock selection often boils down ultimately to a first impression – a gut feeling Company X is dodgy/above-board, enjoys positive/negative investor sentiment, is well/poorly run, always/never delivers, is high/low growth, is financially weak/bullet-proof, has huge/no business or upside potential, etc. Basically, we’re making a snap decision whether it’s a good or bad company…
Such first impressions often exert a substantial & pernicious influence on our stock valuation process. We cherry-pick data, we discern & extract more favourable or unfavourable trends, valuation multiples contract or expand, inconsistent ratios are conveniently ignored, etc. etc. Given similar financial/operating histories, quite often we (wittingly, or unwittingly) end up arriving at radically different valuations for different stocks/companies.
Of course, their respective prospects may entirely justify wildly different valuations. Sure, but for the majority of companies, they generally don’t experience hockey stick growth out of the blue, nor do they suddenly fall off a cliff… [Novice investors are particularly susceptible to the ‘hockey stick’ assumption, blithely ignoring the fact they/other investors have sometimes been waiting years already for the same exceptional growth surge!] In reality a company’s future tends to reflect its past, good or bad, far more often than investors might credit – its management & culture, for example, can be a powerful institutional imperative ensuring this is true.
Multiply this potential for valuation bias across all investors, and inevitably you tend to end up with a pretty inefficient/irrational market…at least in terms of individual stocks & sectors. [Ooh, the heresy!] But a mystery stock challenge can wonderfully illustrate how under/over-valued individual stocks can actually become in the market. Plus it’s a highly effective way to separate the (quantitative) stock valuation process from the (more qualitative) stock selection process – and when the companies stand revealed, investors can examine (individually & in aggregate) their stock valuation process & potential biases in a far more detached and objective fashion. Ideally, it also provides some up-close insight into the perspectives & valuation techniques of a broad selection of investors.
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Wexboy 