Building Wealth Doc's note: How do you pick stocks? That's a question I – and my fellow editors – often get from readers.
Today, Whitney Tilson shares common mistakes investors make and how they taught him to become a "make money" investor...
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I had it backwards my whole career...
For most of my time on Wall Street, I was an old-school value investor. That meant I dug through the "bargain bin" looking for stocks that traded at low multiples of earnings, cash flow, or book value.
Of course, I cared about the quality and future growth prospects of the companies I invested in, but to me, that part was secondary.
The problem was that the cheap stocks were usually cheap for a reason... because the underlying businesses were lousy. So the seemingly cheap stocks turned out to be value traps – they just went down and down as the businesses declined.
But a few years ago, I changed – and improved – my approach to investing and how I pick stocks...
You see, falling for value traps is just one of the four mistakes that tend to plague classic value investors. The other three are:
- Failing to buy high-quality businesses because their stocks don't appear cheap.
- Selling great businesses too soon because their stock prices seem "too high."
- Failing to understand and appreciate powerful new technologies and trends.
I'll confess – despite all of my successes during my more than two decades in the markets, I've made every one of these errors.
I want to emphasize, however, that the lesson here is not to just do the opposite and buy the stocks of great growth companies irrespective of valuation. Growth investors frequently make the following mistakes that are, in many ways, the inverse of the ones value investors make:
- They overestimate future growth, forgetting the powerful force of reversion to the mean.
- They miss the impact of changing technology, new competitors, size acting as an anchor to growth, etc. Trees don't grow to the sky.
- They pay too high a price for a stock, such that even if the business performs well, the stock doesn't.
- They fall in love with their stocks and fail to sell when they should.
- They get sucked into "story stocks" in the hottest, most overhyped sectors where expectations are way out of line with the fundamentals.
The truth is that both quality and price matter...
But they're not equally weighted. I estimate that 75% of what determines a stock's performance over time is how the company performs, and only 25% is the valuation at the time of purchase.
Unfortunately, for my entire career I had this backwards: I looked among cheap stocks and tried to find good businesses when I should have looked among good businesses to find reasonably priced stocks.
That's why I changed my approach...
Today, rather than being a classic value investor, I call myself a "make money" investor – meaning that I try to combine the best of value and growth investing.
It's the best way to capture the upside – and avoid the common pitfalls – of both styles of investing.
So stop digging in the bargain bin. Instead, look for high-quality companies and wait until you can buy their stocks at a reasonable price. If you are smart, courageous, and patient, you will crush the market.
Best regards,
Whitney Tilson
Editor's note: Last week, Whitney shared an urgent market update. This isn't for the faint of heart. It's for folks who recognize we're entering a very tricky time in the economy and are ready to take steps to protect and grow their portfolios this year. If you missed it, click here to catch up on all the details.