What's Behind the Numbers?: A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolioby John Del Vecchio, Tom Jacobs
Learn how to detect any corporate sleight of hand—and gain the upper hand with smart investing
Investing expert John Del Vecchio and “Motley Fool” Tom Jacobs offer a compelling arguement that the secret to stock-market success today isn’t finding the next Google or eBay, but avoiding the next AIG or Enron. To/i>/p>/b>/i>
Learn how to detect any corporate sleight of hand—and gain the upper hand with smart investing
Investing expert John Del Vecchio and “Motley Fool” Tom Jacobs offer a compelling arguement that the secret to stock-market success today isn’t finding the next Google or eBay, but avoiding the next AIG or Enron. To that end, they offer simple, clear techniques for detecting when and how legitimate companies make their numbers look better than they are.
What's Behind the Numbers? offers seven rules for finding companies playing with—rather than by—the numbers and explains how to avoid losing money by determining exactly when a stock is about to head south.
John Del Vecchio, CFA, serves as a Principal of Ranger Alternative Management and principal of Parabolix Research, Inc.
Tom Jacobs is lead advisor for the Motley Fool Special Ops, a stock service where he manages a special situations and opportunistic portfolio. He is cofounder of Complete Growth Investor LLC.
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What's Behind the Numbers?
A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio
By John Del Vecchio, Tom Jacobs
The McGraw-Hill Companies, Inc.Copyright © 2013John Del Vecchio and Tom Jacobs
All rights reserved.
The Real Risk of Stock Investing
Most stocks lose money. That's right, so forget about the financial services industry's mantra to buy stocks and hold them forever. Ignore the moment-by-moment media anxiety—Dow up! S&P 500 down!—that plays to the emotions of fear and greed to grab your eyes, ears, and money. Instead, stay calm and look at the data, not the marketing.
Consider the longest secular bull market most people today have ever experienced, 1983 through 2007. Blackstar Funds studied all common stocks that traded on the NYSE, AMEX, and Nasdaq during this period, including those delisted. They then limited their research universe to the 8,054 stocks that would have qualified for the Russell 3000 at some point from 1983 through 2007. During this period the Russell 3000, accounting for 98 percent of U.S. stock liquidity, rose nearly 900 percent, yet:
* 39 percent of stocks had a negative total return. (Two out of every five stocks are money-losing investments.)
* 18.5 percent of stocks lost at least 75 percent of their value. (Nearly one out of every five stocks is a really bad investment.)
* 64 percent of stocks underperformed the Russell 3000. (Most stocks can't keep up with a diversified index.)
* A small minority of stocks significantly outperformed their peers.
Blackstar provides the stark reality supporting the last point: The best- performing 2,000 stocks—25 percent—accounted for all the gains. The worst performing 6,000—75 percent—collectively had a total return of 0 percent.
It's obvious that a few stocks are responsible for all the market's gains. This shows why it is essential to avoid the losers—and that there are valuable opportunities to profit from shorting, even in a bull market. But the long-only investor has it far worse: To garner real returns, that investor has to be extraordinarily lucky to pick only the outperformers and none of the portfolio-destroying disasters. The odds don't favor this.
Imagine you are reading this in 1979 and we told you that General Motors, Woolworth's, and Eastman Kodak—strong and undoubted Dow components—would in 33 years all be bankrupt. You would never have believed us, yet it's all happened. Large brand-name stocks give the illusion of stability, but there is none. They join the index long after their periods of greatest growth, when their size guarantees a future of GDP growth at best. What are the odds you would have picked only the survivors, let alone the winners?
But let's assume for a moment that you possessed the extraordinary good fortune to pick only the 25 percent winners in the Russell 3000. You probably still don't win. Human nature can't take the pressure of the roller-coaster ride.
Consider Ken Heebner, whose results at Loomis-Sayles Peter Lynch called "remarkable." Heebner opened his own mutual fund business, and on March 25, 2010, his CGM Focus Fund had racked up annualized returns of more than 18 percent since January 2000. That's starting before the 2000–2002 crash and including 2008. These returns are unbelievable, but what happened? Investors behaved like ... people. They poured money in after his 80 percent return in 2007, just in time for the fund's 48 percent drop in 2008. Morningstar modeled the fund's cash inflows and outflows to find that the typical investor actually lost 11 percent per year, despite CGM's 18 percent annualized gains, selling during downturns in CGM's performance and buying at upturns.
Instead of buying more during or after Heebner's or any other great investor's disastrous periods such as calendar year 2008, investors sell. Heebner's contrarian success comes with great volatility that most can't handle. Investors chase last year's winner, buying high and selling low.
If most stocks lose money and most investors' emotions get in the way of profits, why invest in stocks at all?
The conventional wisdom for investing in the stock market is to grow savings beyond the rate of inflation. While experienced investors understand the concepts of nominal (the actual number) returns and real (the number minus inflation), most investors do not make this distinction. They are happy when their stocks are up nominally and unhappy when down nominally, even though inflation and deflation make the numbers irrelevant to what that investor has actually gained or lost. Real—inflation adjusted—returns are all that matter.
The conventional wisdom is right, because inflation does destroy the purchasing power of paper money. Unfortunately, whether the stock market provides the real returns to mitigate or eliminate that threat depends on when you happen to live. Average annual real returns may or may not be positive and, even if positive, may not be for long periods. Beating inflation is likely an accident of birth. Examine Table 1.1 of the S&P 500, including dividends, from 1950 to 2009.
The 1950s skew the results dramatically. That decade produced the lowest annual inflation of all. Figure 1.1 shows the table information starkly and emphasizes the flat nominal returns from 1968 to 1983 and devastating real returns. Then, the 1980s and 1990s produced truly excellent annual real returns, followed by poor ones.
The data require more analysis. Unless an investor dollar-cost averages (invests roughly equal sums at regular periods) in the S&P 500 with these dividend yields, that investor risks choosing the majority of stocks that do not produce the S&P's average and/or have lower or no yield, reducing or eliminating the benefit of reinvesting dividends. Remember, most gains in the stock market averages come from a minority of stocks.
Problems with Dollar-Cost Averaging
But even dollar-cost averaging is no panacea, because incomes and savings increase with age, and age reduces the time available for compounding. It is completely random whether a person's high-wage-earning years and greater investing returns occur during high or low inflation and therefore times of high or low real returns. During tough economic times, income and savings may not increase with age.
And human nature also puts the kibosh on dollar-cost averaging. Benjamin Graham and David Dodd notably described the simple problem, captured by Jason Zweig:
Asked if dollar-cost averaging could ensure long-term success, Mr. Graham wrote in 1962: "Such a policy will pay off ultimately, regardless of when it is begun, provided that it is adhered to conscientiously and courageously under all intervening conditions." For that to be true, however, the dollar-cost averaging investor must "be a different sort of person from the rest of us ... not subject to the alternations of exhilaration and deep gloom that have accompanied the gyrations of the stock market for generations past."
"This," Mr. Graham concluded, "I greatly doubt."
Graham didn't mean that no one can resist being swept up in the gyrating emotions of the crowd. He meant that few could. To be an intelligent investor, you must cultivate what Graham called "firmness of character"—the ability to keep your own emotional counsel. Otherwise, you risk ending up like Morningstar's estimate of the average investor losing money in Heebner's super- performing CGM Focus Fund, buying high and selling low.
To preserve the purchasing power of your money against inflation and grow it at a higher rate, you must invest early, with discipline, and for a long time or earn multiples of your wages later to make up for the shorter time period availabl
Excerpted from What's Behind the Numbers? by John Del Vecchio, Tom Jacobs. Copyright © 2013 by John Del Vecchio and Tom Jacobs. Excerpted by permission of The McGraw-Hill Companies, Inc..
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Meet the Author
John Del Vecchio is the cofounder and co-manager of The Active Bear ETF, a fund dedicated to shorting individual stocks with fundamental red flags. Previously, he managed a hedge fund for Ranger Alternative Management, L.P. In addition, he worked for well-known short seller David Tice and famed forensic accountant Dr. Howard Schilit. Del Vecchio coadvises the Motley Fool Alpha long-short newsletter.
Tom Jacobs, is an investment advisor and portfolio manager with Echelon Investment Management in Dallas. He applies this book's earnings quality tests to value investing for clients.
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