Four Principles to Boost Returns

By William Bias - July 4, 2012 | Tickers: BZH, C, COH, GOOG, MCD | 0 Comments

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Nearly six years ago, in October of 2006, I became a member of the Motley Fool Caps Community. This is a bulletin board or game where the player can select a company, rate the company, give a thumbs up for outperform, or thumbs down for underperform. If a company moves in the direction predicted in a fashion that exceeds the S&P 500 then your score for the pick is positive. If it underperforms the index then the score for the pick is negative.

You receive a score that is a total of your active picks and inactive picks. A player also receives an accuracy score based on whether your pick is going in the direction predicted. Finally you get a player rating that is a calculation based on accuracy and scoring which ranks you with other players on a percentile basis. You can learn more about the game here.

So how did stockdissector (William Bias) do over the past 6 years? Not very well. As of 07/02/12 my score was a -80.74. My rank is 59,865 out of 74,650 with an accuracy of 29.46%. My player rating is 19.81. I am not very happy with this; however, I did learn a few things about myself and stock market psychology along the way. It also reaffirmed some things that I have read about, and that this game has brought out in practice, at least in fantasy.

I have learned and relearned four very important principles by being a member of the Motley Fool Caps Community over the past 6 years:

• Knee-Jerk and panic based reactions are detrimental to one’s portfolio. When an investor sees a stock going in the direction they don’t want the first reaction is to panic. There were a number of picks that I had chosen that I predicted would go down over 5 years. In the short time that I had these companies on my active picks list, short term market enthusiasm caused these companies to outperform against the S&P 500. I panicked and deactivated my picks, but what I didn’t realize at the time was that I was locking in the negative scores. Over time these picks did underperform as I originally predicted, but I was unable to reap the gains or elevation in rank status. For example, on 01/22/08 I initiated an underperform rating for Ambac Financial (NASDAQ: abkfq.pk) between 01/22/08 and 01/30/08 it gained over 115%. I panicked and deactivated the pick locking in a negative score of 108.69. Two years later the company declared bankruptcy. Beazer Homes (NYSE: BZH) spiked 28.21% in 14 days and I deactivated the pick out of emotional frustration. This company has suffered from red ink due to the housing crisis and its stock price right along with it. Citigroup (NYSE: C) has suffered from stock market losses stemming from stigma associated with the financial crisis. If I had the patience to hold on to these picks I would have reaped a great increase in my score, rank, and accuracy. This is allegorical to what happens to real investors when they panic sell at a loss only to see their investments outperform in the long run. This leads to the 2^nd important principle I have learned…Investing for the Long-Term does work.

• Investing for the Long-term does work. Investing in superior companies at a low price over the long-term is the better way to go. Less trading means less payment to the stock broker in brokerage fees and commission, and if your trade is in a taxable account, a payment to the IRS. When I realized what I was doing to my ranking I paired down my list of active picks to 11 based upon earnings growth, low debt to equity ratios, and market dominance. As a result my entire active picks that are more than 4 years old are outperforming the S&P 500. Looking at my two best performing active picks Coach (NYSE: COH), which has experienced growth in its free cash flow of 8.43% per annum over the past 5 years, is my best performing active pick that is over 4 years old at 157.58% versus S&P 500 gain of 11.84% from 01/22/08-07/02/12. A $1,000 investment in the S&P 500 made at that time would be worth $1,118.40 as of 07/02/12. A $1,000 investment in Coach would be worth $2,575.80 as of 07/02/12. Robust domestic and international growth in demand for Coach’s handbags and accessories drive this company’s stock price. McDonald’s (NYSE: MCD), my second highest performing pick has returned 134.44% versus S &P 500 return of 2.67% since 09/12/2007. Its growth in free cash flow since 2007 is 10.83% per annum. McDonald’s has benefitted from a surge in demand of its high quality yet cheaply priced food and market enthusiasm for stocks that are deemed “recession proof”.

• Low Valuations are correlated to superior performance. Looking at my 2nd lowest performing pick that is more than 4 years old, Google (NASDAQ: GOOG) is an example of overpaying that can lead to lower returns. Google has just returned 10.25% since 09/18/2007 versus -3.45% for the S&P 500 despite the fact that the growth in free cash flow has been 34.77% per annum since 2007. At the time Google had a lofty P/E ratio hovering around 44. Google and technology in general has suffered from waning enthusiasm from the market in recent years due to fear of obsolescence of certain technologies such as the PC and questions about who is going to dominate the technological landscape of the future. This reason combined with the high valuations contributed to the lower return relative to my top two picks despite the robust growth in free cash flow. McDonalds had a P/E ratio of 29 in September of 2007, but market enthusiasm for stocks that could withstand recession probably helped this stock overcome its relatively high valuation. Coach had a fairly low P/E ratio of 16 at the time of the pick.

• Due diligence is always required. A number of underperforming picks in my inactive picks were done on a whim. This probably happens when people pick stocks for their real life portfolio. They buy based on nostalgia or other emotional reasons such as hopes for a quick profit and then sell when they feel like they made a mistake. Always research the company’s SEC filings to check out things such as how much cash the company is generating, how much debt is on its balance sheet, etc. Develop a sound thesis for your investment and don’t make a decision based on my or anyone else’s word alone.

Final Thoughts

The Motley Fool Caps game is great for practice. In real life it is difficult to earn back money or to find an investment just to recoup the losses. Be patient, invest for the long-term, don’t overpay for investments, and always research. This is what I learned from playing the game and from 20 years of investing.

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