Resist the Urge to Prove Yourself Right

There are so many sources of investment data that you can easily find support for any hypothesis. Whether you think a particular stock will rise or fall, there are ample data to back up your judgment. The key to great investing, therefore, is not gathering data, but understanding what it means in relation to the stock market as a whole. And that understanding can only be achieved through critical thinking.

Earnings Multiples Indicators

Investors frequently rely on earnings multiples, such as the price/earnings (P/E) ratio, as a guideline for stock buy/sell decisions. What constitutes a "cheap" or bargain stock, however, can vary depending on which earnings multiple you choose to apply. Many analysts believe a P/E ratio of 15 or less is cheap. Disciples of earnings before interest, taxes, depreciation, and amortization (EBITDA) multiples say 7 or 8 is considered cheap. So, while you may think stock XYZ is a sell because its P/E multiple is 66, the doctor next door loves XYZ because its EBITDA multiple is below 4.

Financials Can Fool You

Satellite radio companies XM and Sirius are hot. If you like them as a buy, their triple-digit revenue growth will back up your belief. If you think they have peaked and are ready for a fall, their negative margins and inability to generate more than 10 cents in sales for each dollar in assets will reassure you.

If you want to become a better investor, allow the big picture to materialize before one or two data points steer you in the wrong direction. It's all too common to first form an opinion, and then look for data to support it. Invariably, decisions made this way are subject to error and investment loss.

Challenging the Market

Active investing means challenging the market— getting the market's opinion on a company and then asking hard questions. For example, what performance is expected of a company to merely achieve the level of valuation suggested by its current stock price? Does the price suggest high or low levels of performance to justify the valuation?

Active investors bet against market opinion. The core of this approach is a continuous search for market inefficiencies. Inherent is the discipline to resist trying to prove you are right about a stock, but rather to question where the market's collective intelligence about a stock's price is wrong. This is a subtle but important insight that can be the difference between being right or wrong about a stock's future movement.

• What is the context of the information? The context of information can be just as important as the information itself. Over the past few years, valuation levels of JetBlue (JBLU) have essentially "priced-in" cash returns at their cost of capital. That's about the same level the company achieved in 2002 and 2003. The problem here is there's no value to growing a business that only achieves its cost of capital. If the firm is paying 6% for its capital and only generates a 6% return, it hasn't created any value. It's only when it can achieve returns in excess of its cost of capital that value is created for shareholders.

How far can the stock go? New products or newly launched businesses are frequently accompanied by breathless press releases suggesting a rosy future for the stock. It's easy to see if the company’s sales are strong, but understanding the expectations in the stock price is what’s important.

What catalysts may affect market efficiency? In the case of inefficiently priced stocks, there must be a catalyst that sends the market a signal that a correction is needed. Without that event, these stocks may never realize their potential.

For example, in 2003, Motorola (MOT) returns had fallen to 20-year lows and the stock price dropped in 6 of the previous 7 years to an incredibly low $8 per share. At that level, the stock price implied virtually zero growth and little chance for improved returns. The depressed price and performance expectation might have continued were it not for one salient event: CEO Chris Galvin stepped down. That catalyst was enough to attract a crowd of investors who otherwise would likely have ignored Motorola's prospects. Combined with an expected change in business strategy, Motorola's stock climbed more than 30% in a matter of weeks and doubled over subsequent months. In addition to management change, earnings surprises and other corporate actions can drive performance.

Questioning with Rigor and Flexibility

In every case, rigorous attention to cash flow is vital. What good are valuation questions that stem from P/E analysis if the P/E is unreliable? Cash flow returns, profitability, and growth help create a foundation for better questions. Is there a surefire method that provides perfect stock picks? Of course not. But could more critical thinking lead us to better investing? Without question.

The Bottom Line

• Do not rely on one source of data before choosing a stock.
• Be an active investor by challenging the market and asking the right questions.
• Try to predict what catalysts may influence the future potential of a stock.

Steven Holt Abernathy is principal and chairman, and Brian Luster is a senior analyst and portfolio comanager at The Abernathy Group in New York. The firm specializes in asset protection and wealth management. The authors welcome questions or comments at 800-342-0956 or info@abbygroup.com. For more information, visit www.abernathyfinancial.com. All of the above examples utilize Credit Suisse HOLT’s CFROI ® cash flow framework.