How To Make Money in Stocks Part 7: Pick Low-Hanging Fruit 156 comments

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Allied to this theme is: don't try to understand the whole world! (actually that was the original title, but I thought the low-hanging fruit thing sounds more professional)

Actually in my view, investing is a very simple process compared to most other forms of work in the world. Not making money from investing, mind you, but the process in itself. All the talk and academic theories about structuring portfolios, optimising risk-return etc, does it really do anything but add two or three percentage points of return over the market (if one is lucky)? But people actually make a good living out of this, not just fund managers, but also service providers like financial consultants, market forecasters, systems providers, and a myriad of financial-related cottage industries. I look at engineers and the gargantuan structures they come up with: aeroplanes, software, building systems .... and I wonder .... it's incredible that the financial industry is paid so much for coming up with so little! (albeit they have the uncanny ability to blow these little achievements up into monumental state-of-the-art triumphs).

The point to all the above rambling is that we are all exposed to, and have generally accepted, a certain line of thinking: that to achieve good market returns, we have to accumulate as much knowledge as possible about as many industries and countries as possible, so that we can find and take advantage of potential misvaluations. That is how the output of the broking industry has been structured: daily market research, continuous company reseach reports, economic strategy reports, etc.

While there is nothing wrong with building a competitive advantage based on superior knowledge, it makes more sense to identify a few key trends, what I call inevitabilities, that have a higher-than-average probability of materialising, and then focusing on them.

The alternatives are what many people tend to do: (1) try to read as many analyst reports as possible, end up being overwhelmed with the info and betting on the popular themes/sectors of the day; (2) try to enter or exit based on different analyst interpretations of the market outlook ie. market timing; (3) buying and holding stocks based on analyst recommendations of their potential. For (1), the investor tends to be late into the buying process, while passive buying into recommended themes based on day-to-day reports will tend to lead to a bloated and overly diversified portfolio. For (2) market timing based on reports has historically led to being whip-sawed by Mr Market. For (3) the buy-and-hold approach is fine but one must think deeply about the stock and be comfortable with holding it for a couple of years (or else you will end up in the value trap, like Temasek with Merrill Leech/ Bank of Assholes).

One can be inundated with all the information in the world, but there is no point if it cannot be converted into useful knowledge. Different economists, for example, can utilise the same facts and come up with diametrically opposite and yet equally plausible conclusions. Who to believe?

Investors should recognise that economic outcomes, like investing, is really a game of probabilities. There is nothing definite that will happen in the future, it not only depends on the structural issues, but also responses such as governmental reactions, corporate maneouvres and that most elusive of all --- public sentiment. Who knows what would have happened if Lehman had not been allowed to fail last year, for example? A different governmental response would have generated a different outcome.

Perhaps it is best to visualise things in this way: at every point in time, there is a range of possible outcomes that could develop in the future, but with different probabilities of happening. The investor's responsibility is not to understand all these possible outcomes, because it will tire him out trying to monitor all of them. Rather, the optimal approach is to pick out the outcome that has the highest probability of happening, and then invest according to that outcome.

All this sounds very mathematical, so let's illustrate with an example. At the start of 2009, the whole world was very nervous with the possibility of economic breakdown, with reports of problems surfacing in the US, the UK, Russia, emerging markets. Contrarians, however, noted that given the depressed valuations, potential returns could be very good should the situation clear up. So, invest or not to invest? Rather than leave the decision to a matter of faith, a better approach would have been to avoid trying to forecast how the entire world economy would pan out, but rather to identify who the strong players were and the actions they were likely to do. Who were the strong players? Only governments were able to borrow at low rates, so they were the strongest. What were they likely to do? They were under popular pressure to save the world, so obviously they had to apply stimulus in large enough quantities to replace dwindling export demand. The remaining research to be done would then have consisted of identifying which governments were in the best fiscal position to apply aggressive stimulus, and then identifying which industries would have been chief beneficiaries of such stimulus packages.

Half a year down, those who had been invested in China infrastructure builders, like China Communication Construction, China Railway, China National Building Materials etc, would have seen their money double or more. The infrastructure builders of China were the low-hanging fruit in January 2009, because China was in a strong fiscal position to finance a stimulus package, and was under strong political pressure to replace weak export demand with a domestic stimulus to keep its target growth rate up. Injection through infrastructure construction was a natural choice because China had a need for it, and traditionally this had one of the best multiplier effects.

I want to bring the issue of market timing into the discussion. Readers of my blog will know my long-standing philosophy: returns from stocks are typically driven by the market/sector/company in general 40/30/30 proportion (this is a philosophy because I have no statistics to prove this, it is more a belief/rule-of-thumb based on experience and logic), but rather than focus on the market, my approach has always been to focus my attention to deriving useful returns from the balance 60% based on sector and company. That's because I have always felt it's impossible to decipher a system of 1000 moving parts ie. the economy.

Well, the belief on the difficulties of deciphering a complex creature like the economy still remains, but I have modified my approach after watching the sychronised selldown in all asset classes (except Treasuries) in late-2008. The "pick low-hanging fruit" approach also works for the economy. Indeed one of the most inevitable outcomes of 2008's subprime crisis, in retrospect, was the danger of collapse facing the financial system. Hence, not only banking stocks, but indeed a risky asset class like stocks, should have been avoided studiously if one identified this macroeconomic inevitability. It was the "low-hanging fruit" of 2008.

What low-hanging fruit are available as of now? Maybe we could start with thinking about what is inevitable based on trends so far. I can think of two. For one, with low interest rates it is becoming difficult to implement monetary policy stimulus further except to print money, and that implies currency devaluation. Two, governments will continue to apply stimulus but they will have to find ways to finance it. That implies they will have to increasingly borrow from capital markets. This has implications on currency and bond markets. The above two will eventually happen, there're no two ways about it; governments have to take measures along these lines in order to reverse the potentially destructive effects of deleveraging. The low-hanging fruit will probably be found in these two markets.