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Lindley Estes is a business writer for The Free Lance-Star and Fredericksburg.com. This blog is on Fredericksburg-area business. Send an e-mail to Lindley Estes.

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To invest with success, know your limitations

When great investors are interviewed about their stock choices, they commonly say that the company’s value jumped out from the financial statements.

Investors focus on different metrics. Some mostly examine quantitative financial factors, while others study qualitative elements such as management and brand more closely. And of course most look at each.

Some super-investors say they focus on free cash flow, while others seem to rely heavily on return on equity. Many investors use stock screens that set up basic parameters for the companies they’re looking for. They’ll then further study the stocks that meet their criteria before jumping in.

One of the more interesting formulaic approaches to investing that I’ve read is Joel Greenblatt’s "The Little Book That Beats the Market." It’s an easy-to-read book that preaches the value of looking at just two factors: earnings yield (the inverse of the price-earnings ratio) to determine a "cheap stock," and return on capital to find a "good stock."

The book also has a free companion Web site: magicformula investing.com. The site allows you to find qualifying stocks of various sizes. It’s fun to surf around the site on occasion and see what companies are there.

Warren Buffett and other great investors say they don’t use magic formulas. They say they hunt for the few investment opportunities that offer a margin of safety that allows them to swing for the fences.

The problem is, these investors aren’t telling you and me exactly what they’re doing to find their bargains. Buffett usually refuses to discuss individual stocks he’s buying, and once it’s disclosed what he bought the prices may have jumped from where he got them.

So where does that leave the majority of amateur (and many professional) investment types who don’t recognize any overlooked value when looking at financial statements?

People often praise Buffett’s ability to look at the numbers "that matter" when judging investment ideas. I pretty much know how to do this when judging baseball players for my fantasy team–I look at a hitter’s OPS (on-base percentage plus slugging percentage). I look at the numbers a pitcher can control–strikeouts, walks, home runs allowed and hit batsmen. Keeping it simple allows you to filter out unimportant data.

But I have no such ability to look at a financial statement and know the crucial things to look for. And that’s OK. Learning your own limitations seems to be one of the more valuable things an investor can do.

You can then focus on finding one or two honest and talented investment managers who can do it for you for reasonable fees, or just purchase index funds.

"It just jumped out at me," you’ll hear investors say. If it doesn’t just jump out at you, accept your limitations and use your time and energy on other pursuits.

Like fantasy baseball.

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Permalink: http://news.fredericksburg.com/businessbrowser/2008/06/01/to-invest-with-success-know-your-limitations/