The Motley Fool

Why picking stocks is hard… but worth it

I look forward to August (and February) each year. Then again, I also look forward to Budget Night, so your mileage might vary.

As someone who earns a crust as a financial adviser (and who picks stocks for a living) those two months are the couple of times each year when the financial fog is at its thinnest.

You see, twice a year, companies listed on the ASX must release their full financials. And if those companies run a standard July 1 – June 30 financial year, the numbers are due by the end of August (for the full year) and February (for the first half of the financial year).

Some (a very few) companies have already reported. Most will come next week and the week after. And some will take up to August 31 to get their numbers added up, audited, printed and released to the ASX.

Once that’s done, many companies won’t release another number, commentary or forecast for six full months. And even those who release announcements to the ASX in the interim will only release partial information, often in the form of a spin-heavy press release.

There’s no such thing as perfect information, especially in investing, but over the next month (and in August each year), we’ll see the most complete set we ever get.

Of course, between now and then, we’ll just wait nervously — to see what the numbers bring, and what the market does with them.

Which can be two very different things.

In a world of perfect foresight, the market would pay a rational price for a company’s future earnings.

Indeed, that’s what the market always tries to do.

But always gets it wrong.

How do I know? Well, if the market was rational and all information was known, share prices would simply increase at roughly the official cash rate, plus ~5% per year.

The latter is known as the ‘risk premium’. In theory, you can get the official cash rate straight from the government, and the only way you’ll get more is to take more risk.

In exchange, you should logically want to get a higher return, as well. And for most people, that tends to be around 5%.

Want more? 

You wouldn’t be able to get it, because the only way to get more is to find a company the market is underestimating.

In other words, if investors, en masse, are too pessimistic, they’ll (currently) pay too little.

When you buy a company’s shares, you’re betting that either growth will be better than the market is expecting and/or that the future P/E (or another metric of your choice) will be higher than it is now.

Pretty simple, no?

Here’s where you’d expect me to say ‘… but here’s the catch’.

Except there’s not one.

It’s not quite that simple, but there’s no catch.

When we pick stocks, we’re looking for companies the market is wrong about.

Maybe investors are misunderstanding a company’s future potential.

Maybe they’re right about some of the risks, but have overdone the pessimism, making the shares too cheap to ignore.

Maybe investors get how good the future could be, but just can’t force themselves to pay up for that promise.

Or maybe the market sees only the short term obstacles but misses the long term potential.

Sometimes, that’s stock-specific.

Sometimes, it’s a whole sector.

And sometimes, like in 2009, it’s the entire market.

Indeed, you didn’t even need to have a particularly sophisticated view a decade ago. You just had to believe that the tough times weren’t going to go on forever.

You didn’t have to be a genius in 2011, but you did have to ignore the doom-and-gloom brigade.

And you don’t have to be a spreadsheet jockey to believe that the long term future is as bright today as it’s ever been.

That’s on a ‘total market’ level, of course.

If you want to beat the market — which you should, otherwise you can just buy a market-tracking ETF and go fishing — then you need to look a little deeper.

But not too much.

Maybe you believe the market is undervaluing our technology sector, even at these ‘nosebleed’ valuations, because they’re only just getting started.

Maybe you think investors are putting too much store in the short-term worries facing retail, but that the future will continue to be bright.

Perhaps you see the potential for the disruptors and innovators to continue to bring down the ‘old guard’.

Or perhaps you’re looking at the potential stars of tomorrow, and figure that even if some fail, the others have the potential to change a small piece of their world.

Because here’s the lie that’s told — or at least believed — by many, perhaps most, investors:

They’re so busy trying to be right all the time, that they forget to focus on their portfolios, rather than individual stocks.

In a parallel universe, Apple never invented the iPod and went broke. Or Facebook never overcame MySpace. In another, Woolies and Coles were decimated by IGA and in yet another parallel universe, Afterpay went to zero, three months after listing on the ASX.

These were possible outcomes. But all of them? At the same time? That’s much, much less likely.

The same is true of the companies that did fail — partially or totally. In another universe, they’re flying high and darlings of the ASX.

See, the idea isn’t to only pick stocks that don’t lose. It’d be great, of course, but it’s impossible to actually do.

No-one knows what the future will bring. Which is great — because that’s what gives us the opportunity to beat the market.

We make bets on where we think the market is wrong.

When we’re right, we beat the market. Where we’re wrong, we lose to the market.

And we have — and will — continue to do both.

What gamblers can teach investors

There’s a misperception about professional gamblers. Most don’t make money (only) by picking which horse will finish first in a race.

Indeed, most pros punt on almost all of the horses in a given race. 

How do they win? By putting their money on the horses they think the bookies are mispricing.

That could be 5, 8 or even 10 horses in a given race. 

By definition, some of those bets will lose. They know that.

They embrace it.

But if they’ve correctly assessed the real odds, and placed bets on the horses they think the ‘market’ is mispricing, they’ll make money.

It doesn’t even matter which horse actually wins, as long as they’ve placed (and sized) their bets accordingly.

Sound familiar?

As investors, we are essentially doing the same thing.

Even better, the ‘house’ doesn’t get a cut (as long as we don’t trade too often, paying lots of brokerage and tax).

Over time, those gains will compound very nicely.

And if we continue to beat the market, that outperformance will compound even more.

How so? Consider a mythical $100,000 invested over 20 years.

At 8% per annum, it’ll become a cool $1 million ($1,006,266, to be exact)

At 10% per annum — an increase of 25% in annual return — it’d become $1.75 million (75% more)

And at 12%, your $100,000 turns into $3 million (okay, $2,995,992).

So, in this case, at least, a 50% increase in the average annual return (from 8% to 12%) actually triples your money.

At The Motley Fool, we’re big fans of super-low-cost, broad, diversified ETFs for people who can’t or don’t want to pick stocks.

We think you’ll do very well, if you can save hard, invest regularly and let time do the work.

But if you are prepared to put the mental and emotional effort into picking stocks (and living with the volatility and uncertainty)?

Well, despite the losers in your portfolio, if you can do it successfully, the result can be very, very worthwhile, indeed.

Fool on!

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Motley Fool contributor Scott Phillips has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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