Highlights in this issue:

*** You could do worse than mimic Buffett...
*** Go for the secret shares...
*** DIY stock picking... and more...

From the travelling laptop of Julie Brownlee...

Dear Investment Academy Reader,

In a topsy turvy market, where can you turn for help? What strategy should you employ? In today's Investment Academy, Tim Bennett from MoneyWeek investigates...

Tim, the floor’s yours…

***

Faced with today’s uncertain economic outlook, investors might be tempted to look to the “experts” – fund managers, newspaper tipsters and professional analysts – for guidance. But that could be a mistake.

1. Don’t follow gurus

Renowned Warren Buffett is a great investor – so why not just copy him? A London School of Economics study showed that, from 1976 to 2006, a portfolio that mimicked Berkshire Hathaway (his investment firm) at the start of each month, earned 10.75% a year above the return from the S&P 500.

But that doesn’t mean the strategy will work for you, says Tim Hanson on Motley Fool. Berkshire is very different now compared with 30 years ago. Its huge size means it can only trade in very large shares, suggesting future returns will be more pedestrian than in the days when Buffett had his pick of the small-caps. Buffett tends to favour “private deals or full acquisitions” because of the Buffett effect (a boost to share prices when he buys). Neither route is open to retail investors.

Following gurus in general is a bad idea because you don’t know why they’re buying, says Hanson. A deal might be motivated by a desire to get on even terms with a rival buyer, or even by tax considerations. You just don’t know. By all means “study Buffett’s shareholder letters and apply those lessons to your investing” or invest in Berkshire if you want a piece of his success. But don’t slavishly follow his – or anyone else’s – share trades hoping to match his returns.

2. Don’t follow the newspapers

A recent study by Lily Fang and Joel Peress for Insead business school ranked stocks by how often and prominently someone wrote about them over the decade ending 2002. They reviewed four US newspapers – The Wall Street Journal, The New York Times, The Washington Post and USA Today. They found that around 25% of shares got no mentions at all. The papers mentioned a few “hundreds of times”. The average chalked up 12 mentions a year.

What’s interesting, says Jack Hough in Smart Money, is the ‘no-media’ stocks “clobbered high-media ones by three percentage points a year”. The very best performers were “small companies with limited analyst coverage and plenty of individual (as opposed to institutional) coverage”. Here the “no-media premium” hit 8-12% a year. The reason is simple. Stocks heavily covered in newspapers tend to be the most popular ones. So your chances of getting in early enough to grab a bargain – ahead of the big investment institutions – are slim.

3. Don’t follow analysts either

To come up with share tips, companies pay professional analysts well. So you’d think they’d be worth  following. Not so, says David Dreman, author of Contrarian Investment Strategies: The Next Generation. He analysed 1,500 US stocks from 1971 to 1996 and found that analysts’ top tips actually underperformed the market 75% of the time. Why?

Analysts set short-term price targets by taking future expected annual profits or cash flows for a company, then expressing them all in today’s money using ‘discounting’, before adding them up. In short, if the ‘target’ value is higher than the current share price, it’s a buy. Sounds easy, but there are big challenges.

One is predicting future profits or cash flows, and knowing how far ahead to look. Another is picking the right discount rate to turn those forecast annual returns into today’s money (R50 you get as profit or rent in two years’ time is worth less than R50 you get now). Cut future returns by 10% rather than 5% a year and you’ll get a very different valuation. The higher a stock’s risk, the higher the discount rate applied and vice versa. You can also use another highly subjective number, called a stock “beta”, to capture this risk. Put it all together and conjuring a share-price forecast is much more art than science.

What to do instead

Do your own research. “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right,” said Ben Graham, who analysed stocks using value investing ratios such as price/earnings rather than following “gurus”.

***

Thanks Tim.

Happy trading!

Julie Brownlee
for The Investment Academy

** This article was adapted from a MoneyWeek feature.