Why I don't use watch lists

I remember as a kid sitting in a chair near our kitchen with my grandfather two chairs away.  I was leafing through a toy catalog.  The catalog's pages were worn and I knew the items and their prices by heart.  Suddenly my grandfather looked at me and said "What are you doing?  Looking at all the things you can't buy but wish you could?"  I was stung by the criticism, but he was right.  I had almost no ability to purchase any of the items.  I was just envying items I couldn't have.  As I reflected on this story recently it reminded me of why I don't keep a stock watch list or research stocks that I wish I can buy someday.

This current moment is all we have.  What has already happened doesn't exist outside of our memory and what happens next isn't guaranteed and is unknown.  We need to focus on the now, because in the now we can take action.  We might regret action taken in the past, but it can't be changed.  We can imagine what action we might take in the future, but futures never work out like we imagine.

When I'm looking for an investment I survey every potential investment candidate available at the current time.  I do this because these are the opportunities that I can take action on now.  From that pool of opportunities I'll research until I find one I wish to add to my portfolio.  

It's happened that I've purchased a number of names from a given pool at once.  I've also passed on investing anything at all if the current opportunity set isn't desirable.  By regardless of the eventual action I take I'm only evaluating the current opportunity set.

This strategy differs from other investors.  Most investors keep a watch list of companies they'd like to invest in at a given price.  I know investors who spend most of their research time researching companies that they might never have the opportunity to purchase.  The idea behind this is that they put in the research hours before an opportunity occurs so when it does finally happen they can act quickly.  This is the theory at least.

Part of the reason the investing public believes that investors should endlessly research companies, even ones they will never purchase is because this is what "great investors" tell them.  In interviews professional investors who understand Marketing 101 utter things like: "we never stop researching" or "We're always hunting for new ideas."  This makes perfect sense when you look at things from their vantage point.  A professional is getting paid for results, and their clients want the assurance that their manager is always at work always ready to make money for them.

I know a number of professional investment managers, some with great records.  I don't know if they're always working, but what I do know is they're always able to meet for lunch or take a phone call, and they're never in a hurry to leave.  It's a very flexible job, and for those with talent and savvy it's possible to earn great returns with less than full time work.  Not that clients would ever know this..

There's a misnomer that hard work generates results.  Work is required, but hard work alone doesn't guarantee anything except for being tired.  The problem with this myth is that if you look at top athletes or the top of anything skilled activity the highest performers are set apart mentally, physically, or genetically.  Some endurance athletes don't generate as much lactic acid as everyone else enabling them to continue when the crowd quits.  Top musicians have an ear for songs and so on and so forth.

If someone doesn't have a musical ear no matter how much they work they will never be a world-renowned musician.  The same is true for any skill set.  Hard work can move you past the average Joe or Jane in the middle of the pack, but hard work won't land you in the top.  The top is reserved for those with an exceptional gifting from birth coupled with time, chance, and some work mixed in.

The same is true for the top investors as well.  Warren Buffett has a gifting that allows him to size up opportunity and act in ways that others can't.  No matter how many annual reports one reads, or how many Munger quotes they parrot, or how many Dempster Mills write-ups they read they'll never replicate him.  It'd be like someone thinking they can become Usain Bolt by wearing the right shoes, practicing in Jamacia and doing the famous bolt stance after each race.

Just because someone famous, or someone in the newspaper (or online) does something doesn't mean that everyone should do it.  In some cases the opposite is true.  Investment managers profiled consider their interviews to be marketing material, not instructional information anyone can use.  In fact the opposite might be true.  Some managers might purposefully leave out their secrets as to give themselves an advantage.  

How does all of this tie into investing watch lists?  I don't think investors need to be researching companies because guru investors proclaim they're constantly researching.  Most professionals are talking to clients, managing their employees, managing their back office systems, prospecting for new clients, and in their remaining time looking for new investments.

Another reason, and possibly a more pertinent reason to avoid watch lists is because the current doesn't mimic the future.  Companies and their results reflect the current and past environments, not the future environment.  This seems like common sense, and it is, but common sense isn't that common either.

Let's take the most common use of a watch list.  One researches a stock that's compounded capital at high rates for years or decades but the current price is too high.  In theory all of this research will enable the investor to act and purchase this quality company once the price is lower.  Here's the problem, no one ever knows what will cause the price to crater.  Maybe the economy hits a recession and this business that's compounded capital sits at the cross hairs of public policy as a result of the recession, will their out-performance continue in the future?  Or how about the situation where the company changes and adapts to the new economic situation, will their past results apply to the future now that they've changed?

When the economic or market situation changes such that watch list stocks are suddenly attractive it's often the case that prior research needs to be discarded.  This is because in the new environment the old research isn't applicable.

Another consideration is whether the prior researched name is still the best opportunity in a market dislocation.  Given two stocks worth a hypothetical $100 per share in a market dip is it better to buy the previously researched company at $80 or another company that isn't quite as high quality for $65?  Maybe the $15 differential in this case is easy to brush away and say "I'd pay $15 for quality and give up that return."  But what happens with the differential grows?  What if it's $80 for the quality company and $25 for a similar company with a few warts?  You'll need a lot of compounding to make up that differential.

When the market crashes dislocations happen quickly and to everyone's repeated surprise prices remain somewhat efficient.  Debt laden companies drop like rocks whereas debt free companies with earnings power don't drop as much.  These quality companies that investors have spent hundreds of hours researching don't drop enough to merit a buy.  Whereas there are companies that drop like rocks that are merely babies thrown out with the bathwater.

I always want to be evaluating the current opportunities, not ones I wish will happen.  Maybe watch lists should be renamed wish lists.  These lists are similar to the toy catalogs I'd browse as a kid.  Full of items that I wished I could purchase.  But now as an adult with the means to purchase any of those toys I don't have a desire to buy them anymore.  This is true for watch lists as well.

20 comments:

  1. Nate,

    This was interesting timing for me. I had just read an article on GuruFocus about a guy's investment research process. He used $COST as an example. It was a great article, he has an extremely thorough process and the insights he generated as examples were fascinating.

    The article generated a small discussion about the value of this process. It clearly would take hours, if not days, to conduct this kind of thorough due diligence. One of the commenters mentioned that it seemed like a waste of time because $COST was way above a reasonable buying range. Why research a stock you can't buy? The topic of buying/wish lists came up.

    One idea is that even if you can't buy this stock (now or ever), you gain a lot of information about it, its competitors and business in general that will help you to evaluate other companies you can buy. There is merit to that idea.

    But the other idea, which I think you've hit on here, is that there is opportunity cost. Spending time researching companies you can't buy means less time to research those that are available at reasonable prices now. And further, the only time a company like $COST is going to trade for a reasonable price is in a broad market selloff or when they've hit some temporary hiccup in operations. Imagining either one of these situations, do you really need to invest hours researching to know it might be a buy? If you've ever been to a $COST store or even just heard of it, and you know the market just crashed 40% and so did $COST, does it require much energy to think to put in an order?

    I am rereading Fisher's book, and on the second condition, a short-term hiccup, he basically says that that will be your primary buying opportunity for companies like that. But again... do you need to put it on a wishlist and do exhaustive analysis to take advantage when that comes along?

    Theoretically, EVERY stock is capable of making it on to a wishlist at some price. It seems like an arbitrary exercise to determine ahead of time what the right price would be for every single stock out there. And as you said, the moment you compute a value the info is stale because things change and by the time that price comes around, if it does, things might be so different from when you did your analysis that it doesn't mean anything anymore.

    This leaves the question of how should one find investment ideas. You've talked a lot about that on the site so I don't expect you to repeat yourself, but it would've been interesting if you had at least summarized a more workable approach in contrast to the wishlist thing.

    ReplyDelete
    Replies
    1. Lion,

      Very well put. I could have had you write this post, it would have been shorter and to the point.

      The Costco example is perfect. It doesn't take long to know it's a good company. In a crash you can get up to speed quickly and decide if the business is impaired or not. That was the gist of the post, that you should be doing the research when the opportunity is presented, not in advance.

      I intended to include a section in the post about the value of research itself. You hit on this. All isn't lost if you read a Costco annual report, or spend 45m before deciding it isn't a good opportunity. By continually looking at companies I have a mental database about some of these names. Then suddenly when the name appears again because the price has fallen I'm already familiar with it. But I'm looking at these companies because I thought they were potential investments in the first place, not dream holdings I'd love to have someday.

      Too many investors get wrapped up in owning the perfect business. I will buy most things at the right price. Unless there are onerous liabilities most assets have an absolute value. And below that absolute value is a bargain.

      Case in point there are people buying/selling/renting houses in the worst neighborhoods in the world. Why? There is a price where owning property and being a landlord there makes it attractive. Would those landlords prefer to own a prized Manhattan parcel? Sure, but they are making the most of the opportunity set presented to them.

      Nate

      Delete
  2. Nate,

    I understand your point, but I disagree with your overall premise about how many investors might use watchlists.

    The main problem I have is with your statement "When I'm looking for an investment I survey every potential investment candidate available at the current time." That is impossible. No one can look at every potential investment at a current time. There are way too many companies in the stock universe to look at every one. You might use stock screeners to filter out most of those companies, but I believe you will end up throwing away some of the best bargains out there by doing so.

    My process goes like this. I read a number of blogs and investment sites or occasionally do a stock screener and find stocks that seem interesting to me. I can go through tons of articles before I find one that gives me one of those 'hey this really interests me' moments. Then I do my own due diligence to determine how much I like the stock. It can take me a long time and a lot of research to get comfortable with a stock. I run a pretty concentrated portfolio. Sometimes I like it, but it's just not at the top of my list. Other times I say to myself this could be good, but I really need more info or another catalyst or something else to make it one of those special investments. These are cases when I will add it to a watchlist. I even have stocks I've sold on my watchlist or companies related to ones I own.

    So I guess for me there are only so many companies I can get to know well and I like to keep tabs on them in case there is an event that may make them worth buying. I'm not just looking for the price to back up.

    Thanks,

    Gregg

    ReplyDelete
    Replies
    1. Gregg,

      Good points, I have a somewhat narrow set of criteria for opportunities. So at any point in time I can screen or look at blogs and see if something matches what I'm looking for.

      As the Lion pointed out above there are opportunity costs to researching. I've written in the past about this on measuring incremental return on research time spent. If I spend 100 hours researching a stock that I invest $10,000 into and it doubles then my return per research hour is $100/hr.

      Whereas if I find some bargains that I spend 2-3 hours researching and they double as well then my return per research hour is $3,333/hr.

      There is a point of diminishing returns to research. But my strategy is probably very different from yours. If you only invest in companies that have ROIC's above 20% for a decade then the universe is small. I will buy almost anything if the price is right.

      Nate

      Delete
    2. definitely some good things in this post.

      the problem with that reasoning in this comment is that it would be irrational for investors starting out with very small amount of money to start learning about investing at all. the benefit of researching without making any money might be more money further down the road when your AUM is much higher -> munger: knowledge is cumulative.

      Delete
    3. Anon,

      This is an excellent counter-point. You're right. If you're just starting out there isn't any other way to learn than to research names you'll never buy.

      Thanks,
      Nate

      Delete
    4. You are equating watch list with research?

      I don't think that's always the case. And Like Anon, I come from the angle of a new/novice investor. A watchlist is a starting point for research. But it's also a way to follow narrower market/industry trends. A way to do less research. A way to get alert for company materials, like annual reports. Or a lot of different things.

      I guess I find your blog super useful for teaching me different aspects of investing analysis, and I'm coming in as a novice seeking to learn. This post seems less geared towards that. From what I'm trying to understand is that, if you put in the research hours upfront, you can stop using watchlist to do constant research because you have the basics to look for good opportunities. Something like that?

      Plus, isn't completebankdata a watchlist?

      Delete
    5. Nate - Yes, I was pretty sure from reading your blog in the past that we have different investing styles. That is certainly part of the difference. I research the companies I invest in for a long time, but generally any investment I do that for is going to be anywhere from 5-20% of my portfolio (I do have small positions where I don't put in that much research). Depending on risk I am looking for a minimum of 50% upside generally within 2 years. Doesn't always work the way I want, but in general I have a very good percentage track record. In the past I used to be more spread out, but I want to listen to keep up with any major position I own (news, conf calls, filings, etc).

      If you are talking about a bank I certainly get it. For the most part a bank is a bank is a bank. Much easier to go through the metrics at any time, find out about the business, pick something you like and not have to worry about it much.

      If I put in a lot of time researching something, even if I don't invest at the moment, I have a very good knowledge of that business to the point where if something happens I might be able to act on it.


      memyselfandi007 makes some good points about what and why he keeps things on a watchlist.

      Regards,

      Gregg

      Delete
  3. Love your blog and opinions/analyst, but your assertion here seems over broad and somewhat problematic.

    As Gregg mentions, to "survey every potential investment candidate available at the current time," seems impossible. Or put another way, you do have a watchlist then, it's just super super big.

    ReplyDelete
    Replies
    1. Villainx,

      Check out my reply to Gregg.

      Nate

      Delete
  4. The watchlist would make more sense to me if I was managing billions of dollars. At that level I would have more time than current opportunities, so if nothing was on the docket I would switch to some more proactive research.

    But it doesn't make sense to me for the 99.99% out there managing small amounts of money, and even more so if they are doing it part-time. Time is valuable, spend it on the candidates that exist out there now that can get you a good return.

    I often tag companies that don't meet my criteria based on the financial statements, but might be interesting or good for learning purposes, but seldom get around to them; there's just too much to read that is of more immediate interest.

    ReplyDelete
  5. I agree with you. I'd add that looking at relatively worse/cheap businesses also yields a more discerning filter for what actually constitutes a truly great business, rather than just mimicking what other people point out as good business attributes. It's much easier to determine if something is not bad, and deduce it's greatness, if you really know what constitutes a bad business. Too many compounder/high roic/moat investors end up falling in love with the upside and completely forgetting the downside, when it's really the inverse that matters.

    ReplyDelete
  6. Dear Nate,

    I love your blog but with regard to your post, I do disagree to a certain extent.

    Firstly, I do not subscribe to the argument that looking at "expensive" companies is wasted time. I do think that researching companies always creates cumulative knowledge. Personally, I think that I learn from each and every company I am looking into. So you never waste time by researching a company and trying to understand the business. You waste time by looking at stock tickers and reading the "Hottest" news etc.
    It is true that many professional investors do other stuff, but that is maybe also one of the reasons why active management underperforms.

    Secondly, for me watchlists are very important for the investment process. I have basically 4 watchlists:

    1) a list of stocks which I owned but sold for whatever reason. This list for me is very helpful to track if my selling decisions are good or if I systematically sell too early

    2) a list of stocks that I analyzed but did not buy. This list is interesting because it gives me some clue if the stocks that I look at contain "winners" or if I only look at losers

    3) a subset of 2) with stocks which I didn't buy because they were to expensive but might consider at a lower price.

    List 3) would be the one you don't like. For me, that is a quite interesting list because of course I have to look into them again when the price goes down but it is not difficult to see if something has changed. If you have done a good analysis and written down the case then it is maybe 1 hour work to do an update.

    List 4) finally is the list with companies I want to research at some time. On this list there are also a couple of expensive ones which I would only start to research if something happens.

    Finally, I have almost stopped to use screeners ? Why ? As I have relativley little time to do research, I want to make sure that I have fun. When I start with screeners, I often only get companies where I have no specific interests and no connection.

    So I switched to a more chaotic but also more enjoyable way of selecting stocks to analyse. Interestingly, this approach created more "hits" per stock analyzed than the screener based approach and was more fun.


    mmi

    ReplyDelete
    Replies
    1. Thanks for the comment, you have a sound approach it seems.

      I'm just not enough of a structured person to keep up with something like that unfortunately. There's a part of me that wishes I could be structured like that, but it's not my personality at all.

      I've found the same thing with screeners, a lot of junk. But I've also found some incredible investments via screening. If I had to calculate returns via screening vs not screening I'd say my returns from screened stocks exceed those that came from somewhere else.

      You and I are also in a unique position by writing. Others send us their ideas. That's the best type of screen, when other investors send along what they think is the creme of the crop..

      Thanks,
      Nate

      Delete
  7. I build watchlists categorically. If I see a rights offering i'll write that on an investment printout with several categories of special situations/general situations on it. Often times when there is not a lot going on I just remember every interesting special situation going on. Screening for current ideas either qualitatively or the old fashioned numerical way is probably the best way to go for 99% of small-potatoes investors out there.

    You could scour around for and read 10 years of annual reports for (insert quality company name here) at more than 30x cashflow OR you could just wait 5 years and buy it at 14x earnings.

    There is an inverse relationship between how high the price is compared to how much research I do. For example with $PIP I bought the stock without knowing what they do or anything because they were going to pay a special dividend at a higher price than I could (at the time) buy it for with an extremely high probability.

    There is a temptation of analysis paralysis. Sometimes this can be a good thing like when the costs of a mistake can be life changing. But most of the time analysis paralysis just wastes an investors time.

    The last several times I've been on Netflix I've spent 100% of that time looking for shows and movies to add to my queue. I never end up watching anything and I always remark about the epic time waste it was. The same can be said for investing with the exception that there is a possibility that the knowledge gained from looking into certain situations can be used elsewhere.

    ReplyDelete
  8. I think studying businesses is fine use of time if you enjoy researching potential investments more than anything else, but at a certain point, why should everyone else pay you, in the form of high investment returns, to keep dumping time into studying reports? We all benefit from mostly efficient, lively financial markets, but past a certain point, we don't need more people researching this stuff. Researching a company doesn't make the company more productive. Even worse, there is, I think, a tendency for us to be tempted to buy stocks at higher prices because we've put so much time into studying them.

    Why not spend the time improving yourself? Everyone is operating at less than his or her potential. Given the amount of money I have, I know that I've made far more money by trying to improve myself and my business than I would have made by owning stocks, on both a dollars-per-hour-of-study and an absolute basis. I think Nate said it very well, that all the investors we look up to got rich by running asset management businesses, not by investing their own money.

    ReplyDelete
  9. Wonderful bit of wisdom here, Nate. A lot of people might be taking you literally, but what you're saying to me sounds like you're sharing more of a general experience rather than an ideology. In other words, if you've been in this business long enough, you know that trying to guess the future and planning things don't give you a cost efficient return most of the time. That's not to say never to do it if you have a good idea, but that your efforts are most wisely used by recognizing what you have right in front of you.

    Not easy to flesh out these experiences with words. You did a great job though!

    ReplyDelete
  10. Nice story. Nice reflections

    ReplyDelete
  11. Great job again! More transparency is needed and we still have a problem with company executives and officers who find ways to keep information about their financials from shareholders, the rightful owners of the companies these executives work for. They can use loopholes in the law to do this. You did some great work on this a while back - regarding "taking a company dark" Investors' rights are not adequately protected if a public company is not required to distribute annual reports or even report a change in ownership to their shareholders.

    ReplyDelete