Can investors learn something from the SATs?
It may be only a few more days to Christmas, but it’s also college application season. A lot of high-school seniors are filling out the Common App, writing and re-writing essays, and anxiously awaiting their latest test scores. And there’s a test-taking technique that kids use to improve how they do on standardized tests that can help investors.
It’s elimination. When they come to a question to which they don’t know the answer, they can improve their scores by eliminating what is most clearly wrong. In a multiple-choice test, someone just filling in the circles gets 20 or 25% correct by random chance. But by eliminating the obviously wrong answers, students can better their odds. They won’t guess right every time, but they’ll do better than if they had left the answer blank.
In the same way, investors can do better by eliminating what’s wrong. If a company’s business model makes no sense—if you can’t figure out how they earn their money—then don’t own that business. If management seems to focused more on politics and celebrity than capital investment and HR, don’t buy the stock. This is a variant of The Loser’s Game by Charlie Ellis. We can be smart by avoiding dumb ideas.
For example, in December of 2000 Enron employed 20,000 people and claimed revenues of over $100 billion. But some analysts started looking in depth at their derivative books and couldn’t figure out how the company was earning all their money. There was a gap between what was reported and what they could confirm. We know how this story ends: Enron filed for bankruptcy in December 2001. The executives used a willful, systematic, and intricately planned accounting fraud to inflate their earnings.
Enron stock. Source: Bloomberg
Investors would have improved their relative performance by avoiding Enron. That was difficult to do: the company was a media-darling, considered a high-flying harbinger of the new economy. It had tremendous price momentum. But it was hard to see how they could turn 2% growth in utility revenues into consistent double-digit earnings growth for themselves.
By looking under the hood—understanding the business, reading the financials—investors can sometimes avoid the big flops. And just like when kids take the SATs, if you can improve your odds—in a low-return world—that just might be enough.
Douglas R. Tengdin, CFA
Chief Investment Officer