Reading, Writing, and Active Investing: Common practices of those who capitalize on inefficient markets

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Reading is a crucial aspect of successful active investing

A good friend (and better money manager) of mine once shared this story with me. He said that Warren Buffet was once asked about how to become successful and knowledgeable. Buffet pointed towards a large stack of books, journals, newspapers, and financial statements and said:

“Read 500 pages like this every day. That’s how knowledge builds up, like compound interest. All of you can do it, but I guarantee not many of you will do it”[i]

500 pages seems drastic but the amount of status updates, Instagram captions, BuzzFeed articles, texts, and Facebook captioned videos we read on daily basis probably bring us close to that 500-page threshold.

As Buffett suggests, we are all capable of reading, and we do read constantly throughout the day. The problem is then a matter of prioritization.

One reason we probably don’t establish the extensive reading habits of Buffett, Charlie Munger, or Elon Musk is because frankly business books, journal articles and financial statements are dull.

However, here lies the great aspect of investing. You do not have to be an expert on business, but you should be an expert on the type of business and product you are investing in. Therefore, read what already interests you! Chances are someone involved with that topic is making money, which means there is probably an investment opportunity. Given that motivation, the financial statements of companies in an industry that interests you may prove to be more interesting.

Now, this does not mean go invest in companies just because you love their products. That is not a valid investment thesis. However, it will expose you to the financial statements and business model of that company, and thus give you experience with determining what the cost drivers, revenue drivers, risks, growth opportunities, and competitive advantages are of that company. In general, you will become a more knowledgeable investor and who knows, maybe those business books won’t be as boring afterwards.

That being said, before investing in a given company as an active investor, you need to know at the bare minimum how the company makes money. In order to do this, you need to read the financial statements and see exactly what the company is doing.

We will look at why it is important for an investor to read, but also why writing is another crucial tool.

The Key Takeaways

  • As an active investor you are concerned with the long-term prospects of an investment rather than short-term price fluctuations
  • There are behavioural biases, among other things, that lead to inefficient markets
  • Inefficient markets create opportunities to buy stocks at a discount
  • Extensive reading of factual information is necessary to identify these opportunities
  • Set small, attainable goals to help make reading part of your daily routine
  • Reading widely will extend your expertise
  • There are alternative mediums for absorbing information that appeal to different learning styles
  • Writing an investment report and thesis will clarify your thoughts on a prospective investment

The Business of Information

At the end of the day, an investor is in the business of information. The more information you have on the market, the economy, and specific companies, the better equipped you are to make an investment decision. This can come from endless list of sources. However, this provides a couple challenges.

One, there is so much information available thanks to media outlets and the internet that is has become increasingly more difficult to decipher what is important and what is simply noise. As a long-term investor, it is important to think about how a piece of information or news will affect the long-term prospects of a business, rather than how it will affect the stock price tomorrow.

Second, institutional investors are most likely faster than the average individual investor at capitalizing on the short-term reactions in the market. That means that attempting to profit in the stock market off the latest headline is likely a fool’s game and will probably incur more transaction costs than returns.

Behaviour and the Efficient Market Hypothesis

The University of Chicago’s Professor Eugene Fama’s Efficient Market Hypothesis (EMH) states that markets reflect all available information, therefore you cannot beat the market because stock prices are fair, as opposed to undervalued or overvalued[ii]. Under this school of thought the only way to outperform the market is to take on additional risk.

Behavioural Economist and author of Nudge and Misbehaving, Richard Thaler, begs to differ. He suggests that we, as people, have behavioural biases that can lead to markets being inefficient.

“The efficient-markets hypothesis remains the standard. That’s true of all economic models, but people don’t make decisions that way” – Richard Thaler[iii]

Thaler is suggesting that one of the underlying assumptions of the Efficient Market Hypothesis, that people act rationally, is invalid. This has tremendous impact on investing because if it’s true then there is potential for assets (i.e. stocks) to be mispriced. In turn, this means that there is an opportunity to find undervalued stocks and experience returns greater than the general market. This emphasizes the importance of reading, gaining more information about a business, and understanding the true value of a business.

Warren Buffet, with an approximate net worth of $73.7 Billion[iv], rather harshly stated his view on market efficiency by saying “I’d be a bum on the street with a tin cup if the markets were always efficient”[v].

But how does “irrational behaviour” lead to these opportunities of mispriced assets?

The first point, which Thaler discusses, is called asymmetric loss aversion. This is the idea that we hate losing money more than we enjoy gaining money. As Thaler puts it “losing money feels twice as bad as making money feels good”[vi].

Connected to this idea of loss aversion is what Thaler refers to as being myopic. In other words, we pay too much attention to daily market swings, known as noise[vii]. If you think about the daily volatility in the stock market it is highly unlikely that the underlying economics of a given business are that volatile in reality.

This idea of being myopic is reminiscent of Benjamin Graham’s “Mr. Market” analogy in his famous book, The Intelligent Investor, which refers to Mr. Market as a salesman who knocks on your door every day asking you to buy or sell stock at a new price, and it is up to you to determine if you are getting a good deal or not[viii].

“The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remember that market prices are there for his convenience, either to be taken advantage of or to be ignored” – Benjamin Graham[ix]

In many cases, our short-term focus and our fear of losing money forces us to give into Mr. Market’s daily solicits. This is supported by market and psychological experiments which have shown that both investors and market prices are more likely to overreact to unreliable information rather than reliable information[x] [See Bloomfield et al. (2000, 2001) as cited in Hirshleifer, 2001].

The solution to this, as Thaler suggests, is to not be concerned with short-term fluctuations and focus on the long-run[xi].

There are many more aspects in behavioural economics as well as behavioural finance that suggest why markets are not efficient, and we will cover more on the blog. However, the general idea here is that if you agree with the notion that stocks can become mispriced, and you also wish to be an active investor, then reading will become a common part of your daily routine in order to discover which assets are in fact mispriced.

Get the Facts

When you’re reading for investment research purposes, you should not be concerned with the most recently headline surrounding a specific company. Rather you should dive into the facts.

Where can you find these financial facts? The company’s annual and quarterly reports are a great start if you want to learn how the business actually makes money. However, fancy accounting can at times cause misleading financial statements. Therefore, it is important to always think critically when reading through financial statements.

Some company’s also have investor conference calls, which are made public, where they overview their quarterly earnings reports. These calls give investors more context into the earnings updates.

When you read a headline about a current holding or a potential investment, you do not want to jump to conclusions and submit a buy or sell order. Rather, you want to look at the facts of the business and see if the reason for this headline will have an impact on the long-term prospects of the business. If your valuation of the business changes it may constitute a transaction. Likewise, if your valuation does not change but the stock price rises or falls, it may also justify selling some of your shares for profit or doubling-down on your position at a cheaper price.

“Look, my job is essentially just corralling more and more and more facts and information, and occasionally seeing whether that leads to some action. And Charlie – his children call him a book with legs” [Working Together: Why Great Partnerships Succeed][xii]

When you’re reading and researching an investment opportunity you do not want to be distracted by opinion. The goal here is to read credible sources, such as financial statements, and then formulate your own opinion on the prospects of that company. Sure, you can cross reference your investment thesis against the general market consensus, but remember, the all-time great investors were not successful because they followed the heard.

“We don’t read other people’s opinions. We want to get the facts, and then think” [Working Together: Why Great Partnerships Succeed][xiii].

Put Down the Stuffy Business Book for Once

“Never invest in a business you can’t understand” – Warren Buffet[xiv]

Don’t get me wrong, I love business books. Business and investing books are a great starting point to learn about investing and how to value a business. They will most definitely help you create your investment philosophy. However, they are not the answer to all.

For any company that you are about to invest in, you need to understand how that business makes money and also the unique dynamic of that industry. In order to become more familiar with a business and industry you need to move beyond the business book and perform your own background research into that company and field. Would you consider yourself an expert on that prospective company and industry? If not, I would suggest continuing your research before investing.

Don’t be afraid to read widely. As an investor you want to expand your expertise and perspective. The more knowledge you have on a wider range of topics will allow you to identify more investment opportunities. This includes fiction as well since fiction fosters creative thinking.

“I really had a lot of dreams when I was a kid, and I think a great deal of that grew out of the fact that I had a chance to read a lot” – Bill Gates[xv]

Bestselling author, Ryan Holiday draws parallels from seemingly unrelated topics because of the fact that he reads widely across multiple disciplines and uses an effective research strategy to keep track of his annotated notes.

“Read widely. Read about anything and everything and be open to seeing what you didn’t expect to be there – that’s how you find the best stuff” – Ryan Holiday[xvi]

Building up a knowledge base in multiple fields will make you a more insightful investor since you will be able to view business models, risks, and opportunities from different perspectives.

Multiple learning styles

Okay, so we hammered home that reading will help you as an active investor, but that encapsulates one significant problem. People have different learning styles!

Sure, everyone is capable of reading 500 pages a day, but not everyone will be able to retain valuable information from extensive reading. Fortunately, there are some informational alternatives that can substitute reading.

First off, you need to identify what style of learning works for you. If its not reading, then maybe you are more of a tactile or auditory learner. Audible is a great resource to find your favourite books on audio. Furthermore, there are a plethora of podcasts and YouTube workshops to assists with various investing concepts.

But what about the facts?

In terms of financial statements, unfortunately they are not available on Audible. However, most publicly traded companies do supply recorded conference calls and investor presentation slide decks that offer segments of the financial statements in a different format.

Start Slow

500 pages is a lot of reading.

So don’t start out trying to hit 500 pages a day. Start out by first trying to enjoy reading. Aim for a lower number, maybe a chapter or two a day. Then as it becomes easier work your way up. Be sure to give yourself an achievable goal. Its not about the page numbers… its about making reading or another form of informational intake part of your daily routine.

Write it down

Finally, before you commit to an investment write it down. As bestselling author, Tim Ferris, puts it:

“What I learned: writing is the fastest way to improve your thinking”[xvii]

Writing down an investment thesis before actually investing your money forces you to identify the reasons why that given investment opportunity has promising prospects. That way, if the characteristics that made it a worthy investment change in the future, you are able to recognize that and adjust your position accordingly.

Writing an investment thesis also forces you to acknowledge other aspects of the investment opportunity. Those could be the risks, opportunities, competitive advantage, industry competition, management compensation, and dividend policy among others.

Ultimately, writing a research report and investment thesis on a prospective investment challenges you to take a stance on the future prospects of that company, fund, or other type of investment. By putting the pen to paper you are subconsciously forcing yourself to identify the above character traits of that investment, which will hopefully reduce any speculative tendencies.

In summary, to become a better active investor ensure that you are not just consuming information but constantly seeking out “the facts”, and then writing down your reasons for investing before committing any amount of capital.

It is an enjoyable process if you are particularly curious about business, the economy, and financial markets. However, it is also a lot of work to be an active investor. Thus, if 500 pages a day is appalling you can always revert to a passive strategy, which in most cases is the way to go.

 

Happy investing!

 

Brandon Belding

Breaking the Trend

Additional Resources

References

[i] Ward, M. (2016, 11 16). Warren Buffett’s reading routine could make you smarter, science suggests. Retrieved from CNBC Money: http://www.cnbc.com/2016/11/16/warren-buffetts-reading-routine-could-make-you-smarter-suggests-science.html

[ii] Investopedia. (2017, 01 20). Efficient Market Hypothesis – EMH. Retrieved from Investopedia: http://www.investopedia.com/terms/e/efficientmarkethypothesis.asp

[iii] Chicago Booth Review. (2016, 06 30). What is the efficient-markets hypothesis and how good a working model is it? Retrieved from Chicago Booth Review: http://review.chicagobooth.edu/economics/2016/video/are-markets-efficient

[iv] Forbes. (2017, 01 25). The World’s Most Powerful People. Retrieved from Forbes: http://www.forbes.com/profile/warren-buffett/

[v] Rattner, S. (2013, 11 14). Who’s Right on the Stock Market? Retrieved from The New York Times: http://www.nytimes.com/2013/11/15/opinion/rattner-whos-right-on-the-stock-market.html

[vi] O’Rielly, B. (11/9/1998). WHY JOHNNY CAN’T INVEST. Fortune, Vol. 138 Issue 9, p173-178.

[vii] IBID

[viii] Graham, B. (2006). The Intelligent Investor – Revised Edition. New York, NY: HarperCollins Publishers.

[ix] IBID

[x] Hirshleifer, D. (August 2001). Investor Psychology and Asset Pricing. The Journal of Finance – VOL. LVI, NO. 4, 1533-1597.

[xi] O’Rielly, B. (11/9/1998). WHY JOHNNY CAN’T INVEST. Fortune, Vol. 138 Issue 9, p173-178.

[xii] Parrish, S. (2013, 9 6). The Warren Buffett Formula: How you can get smarter. Retrieved from The Week: http://theweek.com/articles/460783/warren-buffett-formula-how-smarter

[xiii] IBID

[xiv] Goodman, A. (2013, 09 25). Top 40 Buffett-isms: Inspiration To Become A Better Investor. Retrieved from Forbes: http://www.forbes.com/sites/agoodman/2013/09/25/the-top-40-buffettisms-inspiration-to-become-a-better-investor/#12d6b1ca250d

[xv] Brown, J. (2017, 01 25). 27 Inspirational Bill Gates Quotes. Retrieved from Addicted2Success: http://addicted2success.com/quotes/27-inspirational-bill-gates-quotes/

[xvi] Holiday, R. (2014, 01 24). HOW AND WHY TO KEEP A “COMMONPLACE BOOK”. Retrieved from Ryan Holiday – Meditations on Strategy and Life: http://ryanholiday.net/how-and-why-to-keep-a-commonplace-book/

[xvii] Ferriss, T. (2014, 12 11). Writing with the Master – The Magic of John McPhee. Retrieved from The Blog of Author Tim Ferriss: http://tim.blog/tag/john-mcphee/

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