Monday, December 20, 2010

Why Stock Picking is For Chumps

My pick of Tanox produced a gain of 70% over my initial investment.  Was this a smart move on my part, just getting lucky, or just riding the wave of a rising market at the time?

I was going through my investment records from years back, and found an interesting trade I made back in the early 2000's.  I bought 100 shares of Tanox, a pharmaceutical company, for $9.85 a share.   A few years later, my accountant called me on April 10th and told me that if I could put $5000 into my IRA, it would reduce my taxes owed to zero for that year.  So I liquidated the Tanox stock, now worth $17.10 a share, along with some other stocks, and put it in my IRA.

I had bought Tanox because of an article I read about their proposed allergy medication, undergoing testing, for peanut allergies.  If you know something about peanut allergies, you know they are spreading like wildfire, and they can be deadly.  I have a friend who breaks out in hives if you say the word "peanut".  It is that bad.

So, you say, I made out pretty good, eh?  Bought for $985 and sold for $1678.99 (minus trading fees).  Not a bad gain in about three years, right?  Well, yes and no.  I also sold other stocks that didn't do as well, some staying about the same, others losing value.  All in all, with trading fees, I might have done better in a savings account, at the time, which were paying 5% interest (remember those days?).

The problem with stock picking is that you can only pick stocks you know about.  Thus, for example, as I go back through my trading portfolio, I see purchases (and sales) of stocks for companies that I knew on a first name basis - retailers I had done business with, companies I had bought products from, or companies I had read articles about.  If a company made an obscure but profitable product, then I wasn't invested in it, because I didn't know about it.

And there are a lot of companies like that out there.  For example, as embarrassing as it is to admit, I mistakenly bought stock in a company called Morningstar, thinking it was the company that made vegetarian sausage (Morningstar Farms is a division of Kellogs, which is doing OK).  Fortunately for me, Morningstar, the software company that sells financial information, is going like gangbusters, increasing in value by 58% since I bought it (I promptly sold my purchase price of the investment, so I will not lose anything on that buy!  The gain I will keep and see where it goes).

This illustrates how the amateur investor has no clue how to invest.  And most people are this way - my parents were, to be sure.  My mother bought stocks, often holding the certificates in her safe deposit box, for companies she heard of because she used their products or they were "blue chip" investments.  The problem with this approach of "pop stock" buying is that you are buying a brand name, which is no doubt why many companies that do not sell to consumers often advertise on Television, particularly public television - to build brand and stock brand awareness.

Burlington Industries, for example, used to have a dynamic advertising campaign in the 1970's for "Burlington house, all through the house!" with an animated stitching pulling back to reveal their logo.  Why would they do this?  There was no store to visit, no product to buy, other than their ubiquitous socks and perhaps Mohawk carpets (like most textile businesses, it has since gone bankrupt).

I can think that these "brand awareness" types of ads are mainly to boost stock prices.  It is like the ads for IBM - no consumers today buy IBM products, so why advertise?

And oftentimes, we as investors have no idea what is going on with the company.  For example, when my Grandfather died, he left all of us kids some stock in Republic Bank of Texas.  I sold my shares, probably to buy drugs.   My unfortunate Sister kept hers, thinking she had the makings of a portfolio.  A year later Republic Bank went belly up in the S&L crises.  My poor sister - she also had an IRA with Lincoln Savings and Loan!   As outside investors, we had no privy to the inside workings of the company, nor could we look over the books.  The best we could do was read the annual reports and scratch our heads.

Trying to find a gem of  a stock and distinguish it from a paste diamond is hard to do.

So how does one find the real unseen bargains in the stock business?  For the average consumer, I think the answer is: You Can't.   If you were an investment guru working for an investment bank, you might specialize in one industry and be able to know all the players, the start-ups and the market.  You could read all the trade magazines and spot the trends, pick the winners and dump the losers.  But you would do that for a living, 40-60 hours a week (or more), and you would live, breath, eat, and sleep that industry, attend trade shows, visit factories, talk to CEOs, sit in on conference calls, write articles, read articles, and basically be a know-it-all about the widget industry.

Compared to that, we Joe Paychecks are lamers.  All we can do is look at the stock price, perhaps recognize a brand name (and think, "Gee, I like that company, their products are neat and the service was OK!" which is really no indicia of future performance).  The stock price tells us only what others think the company is worth, and often that is a skewed value.  Because so many of those others are chumps like us, responding to quarterly earnings reports.

For example, as I noted in my previous SEARS post, the stock peaked this summer at $125 a share, probably because management cut costs to the bone and improved profits.  Then the share price tumbled to nearly half that and stayed there.  Why?  Perhaps others realized that cost-cutting was not going to bring back market share, but rather drive it away.  Aging dilapidated stores and underpaid staff was not going to increase market share.

But if you bought the stock because the man at the tire center at the store near you was nice to you and you got a good deal on tires, well, that is a pretty lame reason to buy.  And if you buy the stock because the 5 year chart shows the stock decreasing in value and you think perhaps it will rebound, that is equally a lame reason to buy.

So what is the answer?  I am not sure there is one.  You can invest in Mutual Funds, which I have, and hope their "experts" who live and breathe these stocks will make the right picks.  You can put your money into savings accounts, government bonds, or CDs, and bank on the poor return but safety of FDIC or government-backed securities.  Or you can invest in tangible things like your home, a business, a rental property, or even gold coins - if you think those things will hold their value or increase in value.  Or you can buy life insurance or an annuity if you think the companies behind them will stand behind their contracts and pay decent dividends.

Or, you can do a little of all of these things and hope for the best.  Frankly, I think that is really all most of us can hope for - the best.

Perhaps 1/3 of my portfolio is in unmortgaged Real Estate, both investment properties and my personal residence.  This may hold its value, or drop slightly in the coming months and years.  The advantage is, it won't drop to nothing in value (like GM stock did) and it is tangible, in that I can put my hands on it and there is no intermediary running it or cooking the books.

I have perhaps 1/6th in Life Insurance, which seems to be a solid investment and is paying back dividends.  But it is not guaranteed by any means, of course.

And 1/3 is in Mutual funds, though Fidelity, Vanguard, and American Funds, which is not guaranteed at all, seems to be making money, but in reality I have no idea what it is invested in.

And a last 1/6th is invested in stocks through a self-directed IRA and an after-tax trading account.  I get to pick the stocks, but as I get older, my confidence in my stock picking has diminished.  I realize now that my "wins" as a younger man were due to an overall rising market, not to any genius on my part.  And I realize now that stock picking is a sucker's game, basically.

But I'll probably continue to play it, to some extent...... at least for a while.

But the volatility of the market and the uncertainty of investments illustrates why PAYING DOWN DEBT is the best "investment" the consumer can make.  While you will never know with certainty if someone at Acme Corporation is cooking the books, or the mutual fund manager you entrusted your life savings to has flown off to Rio, if you PAY OFF DEBT, you know for certain that you never have to pay that debt again - or interest on it.  If you own your life - free and clear - it is a fixed asset that can never go down in value.

On the other hand, investing in risky stocks while carrying high debt balances is a risky game, which as we saw in this last recession, can come back to bite you on the ass, big time!