Building a Great Investment Team

Over the holidays, I finally got around to finishing Moneyball, Michael Lewis' book about how the Oakland A's managed to win so many games despite having one of the lowest payrolls in baseball. Though the book is technically about baseball, the larger theme of the story is that conventional wisdom is often just plain wrong.

For those of you who missed the reviews, the basic story is this: The Oakland A's drafted or traded for players with undervalued skills (walks, on-base percentage, control of the strike zone), while avoiding or selling players with overvalued skills (running speed, pitching speed, base-stealing ability). By looking for consistent, but decidedly un-flashy players that other teams had overlooked, A's general manager Billy Beane was able to build a team that won more games than many teams chock-full of superstar players.

While the obvious investing lesson is simple--you’re generally better off going against the grain than following the crowd--there's more to be gleaned from the A's story. After all, Beane bought undervalued traits of baseball players and sold or avoided overvalued traits, and we can do the same thing in the stock market. So, in the spirit of building your own winning set of investing skills, I've compiled a list of company traits and investing practices that I think are "undervalued" and "overvalued." Since the heart of investing successfully is finding inefficiencies in the market, you'd be better off seeking out the undervalued traits and practices--the ones that most people ignore--and avoiding the overvalued or popular ones.  

Overvalued: Acquisition-fed growth. Undervalued: Internally generated growth. Wall Street loves acquisitions because they generate headlines and investment-banking fees. Unfortunately, acquisitions fail to add economic value more often than not, so look for companies with a quiet, solid track record of growing through their own efforts.

Overvalued: Initial public offerings (IPOs). Undervalued: Spin-offs. IPOs are sold to the highest bidder amidst a slew of hype and propaganda, while spin-offs quietly come to market when a parent firm casts off its unwanted progeny. Which do you think has the better long-term track record for investors? Hint: It's the one that no one initially wants, not the one that everyone clamors for.

Overvalued: Well-known firms in big industries. Undervalued: Leaders in niche industries. This inefficiency stems from the industry-oriented way research is done on Wall Street. In order to do a good job researching a company like  Cintas (CTAS) or  Moody's (MCO), an analyst has to go out and learn the dynamics of a brand-new industry. Since there are few other public players in niche industries, all that research results in just one more stock on his or her coverage list--whereas an analyst who becomes an expert on semiconductors or retailing can leverage that industry knowledge into a lot more companies. So, small and offbeat industries aren’t as well followed, which means more opportunity for those willing to do some digging. (For example, Moody's and Cintas are each followed by about a dozen Wall Street analysts, while a lower-quality firm like  Advanced Micro Devices (AMD) has 29 analysts tracking its every move.)

Overvalued: What the stock has done. Undervalued: What the company is likely to do. The market tends to chase hot stocks up, and run away from dogs when they're sinking. However, the recent short-term performance of a stock has absolutely no bearing on the future long-term performance of a company. Ignore what the stock chart looks like over the past few months and spend your time thinking about whether the company is still healthy, and you'll be a better investor.

Overvalued: What everyone else is doing. Undervalued: Common sense. Humans are social creatures, and so we often look for "validation"--we like knowing that others agree with our courses of action, because then we don't feel quite so stupid if what we do turns out to be wrong. Unfortunately, being able to blame everyone else doesn’t make a financial loss go away. So, when common sense tells you that a stock or industry is priced for perfection or is too cheap to pass up, don't worry about what the crowd is saying. Listen to yourself, because you’re the one making the investment.

Overvalued: Retained earnings. Undervalued: Dividends and share repurchases. There's nothing wrong with a company hanging on to its earnings and plowing them back into the business; in fact, that's exactly what you want a company with lots of great internal investment opportunities to do. But companies often plow money into dubious projects rather than returning it to shareholders. In fact, a recent academic study showed that companies with high dividend payout ratios actually had higher subsequent earnings growth than companies that retained lots of their earnings, which is exactly the opposite result than conventional wisdom would have expected. Moreover, the tax cut on dividends has made dividend-paying stocks even more attractive over the past year. (You wouldn't know this to look at the market, of course, since it has been speculative stocks that have really led the charge over the past 12 months.)

Overvalued: Flashy businesses that sound exciting. Undervalued: Steady businesses with wide economic moats. It's easy to get worked up over a company that unravels the human genome or invents a great electronic gadget, but firms like these turn out to be flashes in the pan more often than not. Over time, companies with strong competitive advantages--or wide economic moats--tend to outperform stocks with weak competitive advantages, no matter how boring their businesses might be. Long-term stock performance is tied to high returns on capital, not headline-grabbing products or services. So avoid the flash and go for the cash.

Shameless Plug
Morningstar's first full-length book on stock investing will hit the shelves of your favorite bookstore on Jan. 2, and is currently available for preorder on BN.com and Amazon.com. (You can also order it directly from Morningstar.) It’s titled The Five Rules for Successful Stock Investing, and it was written by yours truly in conjunction with Morningstar's stock analyst staff. The first half of the book covers the basics of fundamental analysis: Developing an investment philosophy, a mercifully short introduction to reading financial statements, a primer on valuation, and a guide to evaluating company management and assessing economic moats. The second half is a series of chapters on each sector of the market--from hardware to health care to banking--that explains industry jargon and helps you analyze complicated companies.