Bad news first: your brain is not hardwired to make you a successful investor.
Throughout evolution, survival was our number-one aim. Long books on cognitive biases are filled with how ill-equipped we are when it comes to navigating financial decisions.
To today’s point: we all are heuristic thinkers, meaning we use mental shortcuts to simplify problems and avoid cognitive overload. Like, “That stock is cheap; it’s trading at a 7 P/E.”
Sounds familiar?
For the record, before we move on: No stock is cheap because it trades at a low multiple, and no stock is expensive because of its high P/E. They both may be worthy of the valuation Mr. Market assigns to them. More on this in my Beyond Dividends book.
How hard do you think it is to access the most popular indicators and multiples like the P/E ratio? Indeed, all are just a mouse click away, completely free. So why isn’t everyone super successful in the stock market?
Because heuristics may have kept our ancestors alive on the savannah, but they don’t work in investing! There must be more to investment success than a handful of widely used (and terribly flawed) metrics that are easy to access, even for a fifth-grader.
By the way, what’s easy will always become overly popular and will thus stop working. As William Bernstein wrote in his book Skating Where the Puck Was, “the first people to invest in an asset class with high expected returns and low correlations enjoy sirloin, while the Johnny-come-latelys get hamburger.” Whenever an asset seemed to offer portfolio theory’s version of the Immaculate Conception: high returns combined with low correlations with other standard portfolio components, it always got discovered, became easier to buy and own, and thus its initial advantage disappeared.
What’s easy and profitable will never last. That’s what financial history teaches us.
Now that you know what doesn’t work, let’s see what does! A gentle warning, which you may expect after the intro: the solution is not of the 2-second click-for-riches kind.
Reading and learning as much as possible about the companies trading on the stock exchange is the basis of everything we do at the FALCON Method. (See the fifth step of our process in this post.) We aim to understand whether a firm has a sustainable competitive advantage that may enable it to earn spectacular returns for its shareholders. Identifying the moat characteristics and understanding the moat’s primary and secondary drivers is absolutely essential to make sound long-term investment decisions. And yes, it takes time and effort—lots of it.
Once we have a picture of a business’s competitive position, prospects, and the most important drivers to watch, we are ready to put together its financial model based on distortion-free metrics (Economic Value Added, aka EVA). This modeling, scenario building, and premortem-like identification of the probability tree’s hidden branches take us to our well-founded estimate of the annualized total return potential the firm’s shares may offer investors at the current price.
Yes, our process involves several moving parts. Nevertheless, by getting to this point, we have discovered and understood pretty well what factors and value drivers are crucial for the company we analyze, and this knowledge sets us apart from the crowd.
If this sounds shockingly complicated, let me assure you that I didn’t start out at this level of knowledge and understanding. I had to learn everything on my own, sometimes the hard and expensive way.
Luckily, you can follow in my footsteps, sparing a lot of time as my Beyond Dividends book reveals my journey in detail, with all the key takeaways that can make you a better investor. I’m willing to wager you’ll never again decide on a stock based on its P/E, and that’s just the beginning.
Seriously, decades of learning and experience are condensed in this easy-to-read, entertaining, albeit thought-provoking book, so grabbing your electronic copy qualifies as a no-brainer investment in your education.
