Why the Quants Will be Consumed by the Flames

Margie is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As an investor, you’re sort of like a detective, investigating whether a company is clean, or if there’s been a crime committed. A call comes in: “Be on the lookout for a 1918 blue Model-T Ford containing armed felons who have just robbed the bank!”

At that moment a Model-T breezes by, with a bunch of mean looking men holding shot guns out the window.

“Hmmm …” you say out loud, “That really was more of an aqua-marine.”

The next day you realize your life’s savings were stolen, and you would have been able to prevent it if you weren’t so attached to your “quantitative” criteria of color.

That said there are a number of investors who only want to look and analyze the numbers a company puts out- the quantitative data. I won’t say it’s not important, it is, but relying only on numbers blinds you to what actually is taking place in the real world, and by the time it is expressed in quarterly reports either the crooks have got away, or the risk premium has moved against you to reflect the new consensus, or, in a positive case, the stock has already shot up and you missed out.

I bring this up because there is a really good column published by the Motley Fool where the author, Adem Tahiri, gives us his “rules based investing” sell signs for stocks.

To sum up what he said, here's his rules:

  1. Lay-offs- when a company announces it is laying off 20% of their employees, it is a sell signal. What company is going to lay off so many people if things are going great? Using the example of Hewlett Packard (NYSE: HPQ) and the 27,000 workers they laid off at the start of Meg Whitman’s reign, the stock jumped in this “cost cutting” move, and now rests about 50% below.
  2.  Management Issues- Specifically the CEO or CFO abruptly quitting, or management being too consumed with the stock price.

To quote Mr. Tahiri: “One of the things I noticed in the brilliant documentary, "Enron, the Smartest Guys in the Room,” was the focus by the filmmakers on managements disturbing obsession with their stock price. Enron Execs’ discussed it endlessly, take a ride in the elevator and there it is on a monitor. That desire ultimately led Mr. Skilling and Lay to cook the books and commit Fraud.”

Mr. Tahiri has decided as an investor, if he sees what he believes to be red flags, he’s not going to let them slide. Kind of the, "where there’s smoke there’s fire" rule.

It seems like perfectly rational logic that at minimum these signs bear further investigation, but apparently some investors only use published numbers in evaluating their investments: “I pay no attention to subjective articles since they mean nothing,” retorted a reader to the column.

The Challenge

Unfortunately this one comment represents the thoughts of many more investors who think the same way. They want to read columns extolling the PEG, versus revenues, versus quarterly expectations, minus accounts receivables and divide it by the intrinsic value of future growth. Does that make any sense? NO!

And you want to know why quantitative data often isn’t worth much? Because Wall Street, drum roll please … often cooks the books.

Example: The banks use mark to market, which refers to “accounting for the fair value of an asset or liability based on the current market price, or for similar assets and liabilities, or based on another objectively assessed "fair" value.”

In Michael Lewis's book Boomerang, (which I highly recommend), he describes this process and how Icelandic banks used this technique to create a mythical balance sheet. One bank would buy an airplane and the other would purchase a yacht for $5 million apiece. They would then sell the assets to one another for $100 million (both would have the same amount of cash as they started,) and thus would show up on their balance sheets an asset supposedly worth $100 mil, whereas the real price was $5 million. Oh my how these banks created “profits”-- til it all blew up.

I’m not saying all companies do this, but good luck coming close to understanding the real profits at various American banks. Those balance sheets are incredibly opaque.

Pay Attention to What You See and Hear

So what should you pay attention to? Simple: Be on the look out for those Model T’s driving by, both good and bad.

I’ve missed those hitching a ride on some of those fancy cars myself. Years ago, I saw people lining up around the block waiting to get the iPhone, was teased for using a PC, saw the same lines out the Apple store for the original iPad, and only recently did I purchase Apple (NASDAQ: AAPL) stock. I completely missed my free ride. I saw smoke multiple times, and never looked for the fire. How silly of me. 

Similarly today I find myself ordering more and more books on Amazon (NASDAQ: AMZN) for my Kindle Fire. I realize the company has me entwined in their web. Now time to investigate the stock! (including the quantitative data, and that PE of 3,000 scares me, but even that bears further investigation)

Take Away

My point is that those of you investors only looking at quantitative data, some of it not only being useless, but opaque lies, will leave you blind to what is taking place in the real world. By the time that data is reported in the form of earnings, you’re left in the dust by the investors who are able to discern trends as they are forming.

And that’s where the real money is made. Feel free to pull over that Model-T and investigate. 

margiecfl has positions in Apple and Hewlett-Packard Company. The Motley Fool owns shares of Apple and Amazon.com. Motley Fool newsletter services recommend Apple and Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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