3 Components Needed for Beating the Market

Time to look back

2004 is over, now we are in 2005. This is time to seriously
look at performance of your personal investment, such as
mutual fund, or individual stocks holdings, etc. Does your
fund beat index last year? Does it beat index over past many
years? How are you doing with your own stock investment
comparing to SP&500 index?

If the answer is “great”, well congratulations. You have
your own way of beating market and making big money already.

If the answer is “not so great”, or “failed to beat index”.
You have got a problem. You need to look deeper into the
investment strategy you used or your fund used. You can not
pretend that there is no problem when in fact there IS a
problem. I know there are just so many people out there that
can not face this. Let’s face it, Almost everyone, include
myself have ego that we JUST do not want to admit failure or
mistake or any hint of it. Here comes the 1st Component
below.

Component # 1 – ego, gut, perseverance

Value investing or investing in general is all about
psychology, ego, attitude, and gut.

Investing is serious business. It is our money, our life
savings at stake. Sometimes biting the bullet with pain to
trash the ego is worth the pain if that makes you more
money. Ego is one thing that we must avoid in stock market
investing business in order to make big money ahead. You can
not hide, you have to compare your own performance of past
many years to SP&500 index. Of course, I am not saying that
you should be comparing every month. It is OK to make some
mistakes, here and there for certain months. However, it is
NOT OK if the performance year over year has been bad. You
have got to change if that is the case.

Although ego is something you should all avoid, perseverance
is something you must treasure if you want to be that
marathon winner. When you finished your due diligence and
you have calculated your risk reward ratio and intrinsic
value, go for it and stick with it. Do not be scared of
negative comments or negative press, even if the source is
from a famous author or from your close family. Value
investing is lonely business. I know this for years. I have
been criticized over past many years for numerous reasons,
for not beeing able to sell at top, for not beeing able to
buy at bottom, for picking a risky bankruptcy related stock,
or for buying a low float small cap stock , blah blah. You
know what? in the end, my investment performance is better
than most of folks out there in the market, including those
“pro” mutual fund managers.

I have got comments like this before: “Blast, I like your
method, I know you are making big money. But, I can not do
as you are doing. I can not hold. Especially bad news hit, I
just have to sell, and my performance sucks”.

Well, if he/she do not have gut to hold like I hold during
bad time, she/he can not make big money with value
investing. One can be all right in paper, right with value
calculation, right with timing of purchase. However, if you
can not fight against panic during minor negative news, you
are out in the investing marathon.

Component # 2 – right method

Many investment methods are flawed, period. This is
especially true for many short term oriented trading
methods. Many mutual funds preach long term holding for
their fund investors, but the fund managers themself engage
in short-term trading like mad men. Performance of many
momentum based growth funds or tech funds looked horrible
for past 5 years. The reason for that is very simple: the
investing method itself. Growth investing or short term
trading sometimes can be very speculative and dangerous.

Wall street has famous theory that “the more risk, the more
reward”. Therefore, yeah, growth funds are risky, but if you
want to have more reward, you have to chase risky stuff.

Wrong. The truth actually is “the more risk, the less
reward”.

I know I am going to be hammered by saying above
non-conventional statement. I put out below example to back
up my point.

Las Vegas is world famous place for gambling. As an average
investor, you visit Las Vegas looking for opportunities to
make big money with $50,000 investing capital. Let’s assume
the theory “the more risk, the more reward” is correct.
Where are the riskiest opportunities out there in LV? Of
course, Gambling. The potential reward can be astonishingly
high. Black jacket, slot machine all have huge potential
with 1000% or even more within minutes. You can make
millions if you are lucky with your $50,000 principal at
slot machine. Actually, it is FACT there are small group of
gamblers who made millions in gambling in LV.

However, If you are sensible person, you know the answer. As
high as the potential reward can be, the most likely result
from gambling with $50,000 principal at LV is WIPEOUT. You
lose all your hard-earned money.

If you are a rich investor with multi-million dollar capital
looking for investment opportunities in Las Vegas. Certainly
casino company stocks and bonds or private offering might be
worth looking. However, the sad news is that no matter for
stocks or bonds or private offerings, the investment reward
is only around 10% to 20% yearly. Well, maybe it is not so
sad at all. 10% or 20% of return is certainly a lot safer
than gambling. Which reward is better, 10% – 20% return or
wipeout?

Well, I know you may want to protest against my above
example. Stock market can not be as bad as Casino, right?

It depends. Although casino gambling does not provide real
investment opportunities as stock market provides, sometimes
stock market can be even worse than casino due to insider
manipulation, cheating books, etc. Over the past couple of
years, I have heard so many negative news from stock market:
Enron, Worldcom, mutual fund scandals, market timing, etc.
But I have not heard of news of slot machine cheating by Las
Vegas Casino company. Casino does not need to cheat to make
money, the odds are against gamblers. Although stock market
does offer real investment opportunities for
businessman-like investors, stock market is also a place for
gamblers to place their bet just like a Casino.

In stock market, the odds are against speculators.

Well, I know you may have more questions. Why Casino bonds
or stock offerings or even private offering is only offering
10% to 20% returns?

Casino business is just another business. Numerous academic
study has shown that in US history of past many decades,
majority of companies can not maintain more than 20% of
return on equity over the long run. Many companies are
operating under loss, a negative return on equity. If you
read books on Warren Buffet method of Philip Fisher method,
you will know that they are experts in identifying those
small group of high return on equity stocks. But for most
companies, they are not as good as the stocks in which
Buffet or Fisher invested.

Competitive economics is also at play here. If a company can
make more than 20% of return consistently, the competition
will heat up and more smart businessmen will enter this
field to drive down the return.

If you think of value investing as special kind of business,
you will realize how hard it is to maintain 20% return for
the long run, as Warren Buffet achieved over past 50 years.
Very few investors can do that. Value investing business is
just as competitive as other business. Let’s face it, if
value investing is not competitive and easy to make big
money consistently, many smart business guys out there in US
will liquidate their own company and start their investment
firm instead.

Component # 3 – right tools – new way to find great picks

Peter Lynch mentioned many methods to get the stock leads
and identify the big winners in his book “One up in Wall
Street”. Tips from wife, tips from friends can land you the
great stock idea. Although his methods are very valid, there
are new ways to find that great pick in this internet stage:
Software Data Mining.

It is quite fortunate that I am a data mining expert myself.
If you are good at data mining, you can do yourself well
too. You can design and fine-tune your data mining tools to
get the leads you want and make big money by getting ahead
of crowds.

A successful value investor really has to find great pick
ahead of big guys and move fast in order to make big money.
In this internet stage, big guys such as mutual funds or
hedge funds really have no advantage over small guys or
small firms such as BlastInvest. At BlastInvest, we do stock
data mining with our in-house software just as good as those
big guys, if not better. Sarbane Oxley new law also helped
individual investors and small firms like BlastInvest a lot
because most of public companies now disclose information to
public and to big institutions simultaneously through
conference calls or press releases. Insiders now also have
to report insider buying and selling within couple of days
of transaction instead of several months before. Whenever
insiders buy or sell, You need to know that immediately
within a few days. You want to buy when insiders buy and you
may want to sell when insiders are selling too.

Don’t despair if you do not know how to program software
yourself. There are lots of tools and services out there to
help you out. Here I want to talk about the most useful
tools out there.

(1) Valuation screening tool. You need at least one tool for
screening against value metrics for you. Yahoo stock
screening is very useful tool and it is free.

(2) Insider buying tool. This is must-have tool to get you
the latest insider buying stocks. There are many offering
there, fee-based or free. We offer free insider-buying
weekly service as well at BlastInvest.

(3) Strategy screen. Validea.com offers an interesting stock
screening tool that can screen based on methods of Ben
Graham, Warren Buffet, or Peter Lynch. It has limitations
too. I have used it and found that its Warren Buffet tool is
not working well and its Ben Graham strategy screening is
only looking for “defensive” type of stocks, not the
“enterprising investor” type of stocks. My BIRTP newsletter
is really geared toward “enterprising investor” type of
stocks rather than “defensive investor” type of stocks.
Heck, still Validea is best kind of tool available at
affordable price in this category.

Final thought

If you follow up with my above 3 components
of value investing, you are on your path for financial
freedom.

However, if you can not do as I stated above, do not naively
believe that you can make big money alone in stock market
mainly by hunch. Buy the stock screening tools if necessary,
get the professional help from real experts and consider my
newsletter BIRTP as well.

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