Friday, November 04, 2005

Investment Lemmas

Do stock prices instantaneously reflect all available information about a company and its industry? While the debate continues, I’ve observed certain investment lemmas (in mathematics, a lemma is a truth used as a stepping stone to a larger result rather than an important statement in and of itself.) These lemmas work for while – until they don’t.

For example, I’ve found two lemmas: it possible to make money in the market by investing in a basket of stocks that ride temporary episodic trends and by finding individual stocks that float upward on guidance momentum. Here’s what I mean:

  • Temporary Episodic Trends. Coinciding with new presidents, I’ve noticed widespread changes in the economic environment. If an investor can identify such "episodic trends" early, there is money to be made. For example, in May 2001, I developed the W-Industrial Complex (WIC) index of stocks in energy, defense, and selected retail and media properties which I believed would benefit from Bush’s policies. Last time I checked, the index was up 150% vs. the S&P 500 which was down 10%. This investment strategy works well as long as an investor is willing to get out before the end of the trend. As oil and natural gas prices tumbled last month, I began to wonder whether the WIC’s viability as an episodic trend was over. When such trends find themselves as headlines in the major newspapers and magazines – as oil industry profits did this week or Amazon.com did in December 1999 (with Jeff Bezos gracing Time’s cover) – it is often a sign to head for the exit; and
  • Guidance Momentum. In my newsletter I have been able to pick a few stocks each year which seem to outperform the averages significantly. In these cases -- such as Boston Scientific in 2003 or Whole Foods in 2005 -- the stocks exceeded growth projections and raised guidance consistently and investors piled into them. Each quarter that these companies were able to beat and raise, new investors bid up the stock. The higher price raised the stock’s P/E ratio – making the inevitable slip up precipitously painful –- particularly for the most recent investors. In the case of Boston Scientific, problems with product recalls interrupted the stock’s upward momentum. Whole Foods has yet to hit its inevitable rough spot – it could be as simple a problem as failing to beat and raise in its next quarterly earnings report. But once a stock falls from guidance momentum grace – it becomes "dead money" unless it can re-establish its ability to beat and raise quarter after quarter.

If investors are lucky enough to identify stocks that pass these tests, they can make short-term profits – as long as they also have lemmas that tell them when to get out.

Perhaps in investing there are no larger results – just the accumulation of small ones.

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