One Question That Makes All The Difference

The Daily Barometer (Oregon State University student newspaper) recently ran a story about a student club that aims to deliver real world experience in the area of portfolio management and stock analysis. The OSU Foundation lets the club manage ~$1.4MM of real money, so it’s more than just a theoretical exercise. It sounds like a pretty good program and the members appear to be earnest and passionate about participating. One part of the article in particular caught my eye:

Within the group, members write up and present reports on their selected companies of interest each term, with analysts receiving support from their section managers and other officers. The sections included in OSIG are technology, industrial materials, consumer goods, financials and healthcare.

Again, this sounds like a good program. The exercise of conducting research, compiling it into a readable report and then presenting the idea(s) to the rest of the group is great experience. Being able to communicate clearly and persuasively is a valuable skill. If I were advising them I would just have one suggestion. One thing they could do that would immediately differentiate them from essentially every stock analyst I’ve read or listened to over the last twenty years.

After you’ve done all your research, after you’ve read the 10-Qs and the annual reports and you’ve pored over the insider activity and listened in on the archived analyst calls. As you’re writing your report and getting ready to blow away the group with a scalding torrent of brilliantly stated logic, ask yourself one question: “At what price will I be wrong?”, and then put the answer in the report.

It’s kind of an interesting question. Most of the time, when you ask an analyst about the downside to their thesis, the commentary remains fixated on the story, something like, “the multiple expansion we expect is largely reliant on a successful rollout of the new MetaWidget line…etc.” The problem with stories is that they can be a crutch, a copout, for when things go bad.

What if the story remains intact but the stock price plunges anyway? This is where analysts and investors get in trouble. Let’s say you buy XYZ at $50 based on a particular narrative for why that is an attractive price. If the price starts dropping, you hear things like:

  • We liked XYZ at $50, but we love it at $40!
  • We think $30 represents a great oppportunity to average down on XYZ.
  • At $20, XYZ has become a very attractive acquisition target.
  • We’ve revised our opinion on XYZ ($10 – NYSE) from BUY to HOLD and recommend patience while the company continues to execute what we think is a solid business plan.

Getting the story right while losing money is pretty much exactly the same as getting the story wrong while losing money. It’s a distinction without a difference. The more relevant issue to focus on is price. The number of variables that can influence the price of an investment are infinite. A story or a fundamental analysis cannot possibly foresee everything. This is why it’s smart to have a circuit breaker. A pre-planned tripwire that defines being wrong in numerical terms. The only way to do this reliably is build it into your initial analysis. Draw a line in the sand that says, “if the market goes against our opinion to this degree, we would recommend exiting the position until a reassessment can be made.” Something like that. Nobody expects you to be right every time, but they do expect you to be objective and realistic.

Managing an investment portfolio can be fascinating. The array of opportunities is seductive – it’s very easy to talk yourself into a great sounding idea. That’s the fun part of the business. It’s also the dangerous part of the business. Falling in love with your own brilliance is the surest way to blow a hole in the portfolio. Learning this timeless lesson at school on the Foundation’s dime would be a fantastic use of university resources. Good luck guys. Go Beavs!

Brad Alvarez, Adam Rosa, Riley Kinser and Pryce Waites will serve this year as 2012-13 Oregon State Investment Group officers. Photo courtesy of The Daily Barometer.


This entry was posted in investment theory, psychology, strategy on by .

About Patrick Crook

Pat Crook is a financial advisor in Corvallis, Oregon with over twenty years of experience. He has developed a specialized form of investment portfolio management designed to address the risk concerns of those in or near retirement as well as organizations like charitable endowments and foundations. To learn more or set an appointment, he can be reached at 541.753.1808.