Small Cap Stocks

Even though investing tends to take on a serious tone in our lives, it is important to sometimes remember that investing, like any other business, is really only a game. Many people, of course, would recoil at the suggestion that investing is only a game, particularly those whose job it is to market and manage the investment game. However, even in the event that you consider investing to be an elevated activity, thinking of it as a game would certainly improve your performance by helping to eliminate the debilitating emotions, such as fear, that wreck most of our daily financial and non-financial decisions. Chess is one of the games that I’ve always loved to play, and in this post I’ll discuss one particular lesson that I think chess offers to those playing the investment game.

If you’ve ever played chess against a particularly skillful opponent or half-decent computer program, I’m sure it got you thinking about the thought processes, or algorithms, that make these opponents impossible to beat. There have been, of course, quite a few books and theories written about chess grandmasters, and how they think. One particularly interesting insight that I have read about is the ability of better players to quickly, and almost unconsciously, eliminate bad plays.

Basically, when most of us look at a chess board, we see a bewildering array of possibilities and it’s nearly impossible for us to figure out what to do. More skillful players, however, because of significant experience and innate abilities, are quickly able to eliminate most possibilities from the set of moves, and thereby concentrate on only a few promising moves. This focus on only a few moves greatly increases their chance of success in finding winning patterns, since with fewer moves there are simply fewer possible combinations and it becomes easier to spot winning patterns, even without looking too far ahead into the game. Ultimately, superior pattern-recognition abilities is what differentiates top chess players from average players, and one of the best ways to improve ones pattern-recognition skills is simply to work with a smaller set of variables.

Following upon this train of thought, one of the best pieces of advice I’ve been given about chess is to stick to the same opening repertoire in every game until you master that one opening. Essentially by focusing on only one particular type of opening, you significantly narrow down the number of possible directions the game can take, and thereby increase your chances of discovering the moves or combinations that work or don’t work in this particular subset of chess moves. Furthermore, even when you encounter new combinations, at least your grounding in one particular opening system, provides you with basic principles that help to eliminate obvious losing moves.

Applying the above insights to the investing game is quite straightforward. To become a more successful investor it is important to be able to quickly, and at some point unconsciously, eliminate many obviously losing investment choices. By eliminating bad choices, one is able to focus on fewer investment ideas and with this narrower set of choices, pattern-recognition kicks in, helping you to more easily spot winning investment combinations.

Taking this a step further, one of the easiest ways to eliminate many losing investment choices is by focusing on one particular “opening” investment move. As it pertains to the stock market, this means that you need to focus on only specific investment situations at the start. For some this may mean sticking to investments in companies with no debt, while for others it may mean investing in only one particular industry. Whatever the criteria, it is vital to stick to only one opening move.

The difficulty, of course in the stock market, as opposed to chess, is in deciding which openings you’ll focus on, since there are so many suggested openings and little evidence for which investment openings have a history of success. In fact, many classic opening moves, such as low P/E’s or low P/B stocks, have been mostly discredited and other opening moves, such as those based technical analysis criteria, make little rational sense. Nevertheless, it’s important to find opening investment moves that have some element of rationality, evidence, and match well with ones innate personality. Then by stubbornly sticking to the same investment moves, you’ll eventually spot some winning patterns that you can exploit to make money.

We recently came across a great post by Tom Brown, a leading hedge fund manager specializing in banking and other financially-related equities. By offering a window into the thought processes of a successful investor going thru a major stock correction, we think the article may be useful for other investors facing stock declines, even in non-financial shares.

By way of introduction, Tom, and several other high profile hedge fund managers, have recently been caught long substantial amounts of shares in the sub-prime mortgage sector. That the stocks in this sector, e.g. LEND, NEW, have taken a beating, is probably a major understatement. So what is Tom’s take on the carnage?

“Is the near-term weakness in the names jarring? Of course it is. But regular readers of this site have been similarly jarred before. We went through it with First Marblehead in late 2005, with Capital One in 2003, and AmeriCredit in 2002. Having been through those drawn-out (and ultimately quite profitable for us) sagas, I have long since given up trying to pick precise bottoms or tops. The best I can do instead is to recognize value when it appears–and then act when everyone else has gone off his rocker. Like, say, now.”

Later on Tom comments:

“But I’ve been through this before. If history is any guide, the next few months are going to be a bumpy pain in the neck. But I continue to believe that the long-term reward will be substantial. This is the stock market. A bell doesn’t go off that tells investors when the risk has passed–and when the outlook does finally seem positive, the stocks will have already soared. But to me, the fundamentals are pretty clear, and bullish.”

We don’t really have an opinion on the sub-prime market, but we think the above is great advice for investors in any sector suffering a correction or a bout of extreme volatility.

If you are interested, you can read Tom’s entire article by clicking here.

In the book "Innovation and
Entrepreneurship", famed management guru, Peter Drucker, provides
a two-line description of the entrepreneurial process that we think can
be modified somewhat to provide an excellent summary of the investment process we, and many others, advocate.

Due to requests from several subscribers, we have prepared an updated
spreadsheet, which details the returns from the picks we have mentioned
on EnvoyGlobalResearch.com and CasinoCapitalism.com over the past year.

I really got a kick out of these three headlines, which were all written today:
Oil Prices Rise to $72 a Barrel in Asia Houston Chronicle
Oil Prices Decline Despite Gulf Storm Forbes
Oil Prices Steady After Iran Reaction Forbes

Ok, wait a second, so which way are oil prices headed? Bets anyone?

Is there a connection between betting at the horse track and the stock market? Benjamin Graham, the father of fundamental investment analysis and one of the most influential investors of all time, seemed to think so. Below are some interesting quotes from lecture ten of The Rediscovered Benjamin Graham, a compendium of transcripts from his lectures given to security analysts in, I believe, 1946. The full transcripts are  available over at Wiley.com.