John Reese is chief executive officer of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.
In South Carolina last week, someone or a group of people won the US$1.5-billion lottery jackpot, the largest in U.S. history. And believe it or not, two winners will share another jackpot of almost US$700-million. Imagine winning both.
For nearly everyone, those odds are impossible to beat. But of course, there is eventually always a winner. If you pick your own numbers, you might be tempted to attribute your lottery success to skill, but there certainly is a lot of luck involved.
The same holds true for investing, at least in the short term.
Michael Mauboussin, the author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing, describes the difference in outcomes as falling on a continuum, with all luck on one end and all skill at the other. Games of chance like roulette skew to the luck side, while activities such as winning an Olympic gold medal fall on the skill side. Most everything else in life falls somewhere in the middle.
But it’s not so obvious with investing. The ability to buy and sell stocks at precisely the right moment to maximize gains and minimize losses is a lot harder than it seems. Active stock pickers have proven this in recent years. And even mutual funds don’t always keep performing well.
You can compare various funds to see which one performs the best at the lowest cost, but selecting that one isn’t a guarantee of future gains. The investor has used skill in picking an appropriate investment, but the outcome isn’t necessarily going to be good. A good part of it is going to come down to luck.
Mr. Mauboussin argues that luck is important in investing, but not because investors aren’t skilled. In fact, he says, the market is so efficient at reflecting information in stock prices that only new information will move them. So, as the collective skill of investors improves, it’s largely luck that separates the winners from the losers.
In other words, in a game where luck plays a role, the outcome isn’t always going to be good.
If that’s the case then successful long-term investing will depend on developing a process, something that will increase the probability of a good outcome over time. While not all processes lead to good outcomes all the time, focusing on the process is a more effective way of removing bias from decision making to increase those odds.
A process should be simple enough to be articulated in writing. Putting it on paper gives the investor something to go back to in times of stress to reconnect with their long-term goals. That keeps emotion in check. It’s also a good jumping off point for periodically reviewing the process and making adjustments as goals change. And in choosing a professional manager, having a written process is a good way of comparing and evaluating them to find the best fit.
A process should also be able to withstand markets in any condition, because no one strategy is going to be a winner all the time. It should be able to weather the downturns that come, and recognize that markets go in cycles. It should also be repeatable and backed by historical research. There’s no sense adopting a process that only works under certain conditions.
Investors often make the mistake of focusing on outcome over process. But by identifying a process and embracing it, investors can gain confidence in achieving their goals for the long term.
Here are some stocks that score highly on our models tracking the processes of some of the biggest investing legends:
- JB Hunt Transport (JBHT) – This North American logistics and transport company scores highly based on three guru-inspired models, including James O’Shaughnessy, chief executive of O’Shaughnessy Asset Management, Peter Lynch, the former star manager of the Fidelity Magellan fund, and Warren Buffett, with persistent earnings per share for the past five years and a relative strength of 61.
- T. Rowe Price (TROW) – This investment management company scores highly on the models tracking John Neff, the former manager of the top performing Windsor Fund, Mr. Lynch, Mr. Buffett and Martin Zweig, a successful manager and author of Winning on Wall Street. It has a projected future EPS growth rate of 17.6 per cent.
- BHP Billiton (ADR) (BBL) – This global resources and commodities company scores well on the models tracking Mr. O’Shaughnessy, Mr. Lynch and David Dreman, a well-known contrarian investor and founder of Dreman Value Management. It has a yield of 6 per cent and a 15.9-per-cent return on equity.
John Reese