"Dartwielding monkey" - Insightful FT article

How not to be a dartwielding monkey - EQUITY RESEARCH - Research is wasted if managers don't know what they are looking for, writes Mark Sellers.
By MARK SELLERS
13 August 2007
Financial Times

Should you spend countless hours researching a stock before buying it, or just a few hours? The common wisdom is that the more time you spend on research, the better your investment results will be. But is this correct?

Not according to studies on the subject. At least two I have seen came to the conclusion that anything more than a cursory review of a company's prospects is a waste of time.

One study showed that sell-side stock analysts, who spend 50-80 hours a week on research and presumably have loads of information at their fingertips, are no better than a monkey with a dart at predicting a company's five-year earnings growth rate. In fact, they are worse than a monkey with a dart because they tend to project the recent past into the distant future, rather than assuming growth will revert to the mean. If the analysts' projections had been simply random, the results might have been closer to reality.

Furthermore, large mutual funds tend to hug the return of their benchmark more closely than smaller funds do, in spite of the fact that larger funds have more resources and presumably are able to do more research. They can pay an army of analysts to research every nook and cranny of a company's business and come up with proprietary earnings estimates and valuation models. Yet more research does not equate to better returns, at least among mutual funds (and I suspect the same is true of hedge funds).

It would, therefore, be easy to conclude that research is a waste of time. But I have a different take on this issue. In my view, the problem is not with research per se. The problem is with the type of research people do. They miss the forest for the trees.

The typical fund manager is bombarded with dozens of news items about his stocks and makes many seemingly important buy and sell decisions every day. The noise doesn't get filtered out. Everything seems important to some managers.

The thought process is something like this: What will the Federal Reserve do at its next meeting? Will company X beat earnings estimates next quarter or miss them? Which direction will oil go from here, up or down, and how might that affect consumer spending? Is the economy headed into a recession? What will company X's stock price do over the next three months? Will the analysts reduce earnings estimates after I buy the stock, resulting in short-term losses? Are analyst estimates too low, so that there is a short-term profit opportunity? Which will perform better over the next year, foreign stocks or domestic stocks?

These are the thoughts of a typical fund manager on a typical day. Thoughts are scattered across a range of subjects, with questions that can't possibly be answered with any accuracy (like those above) gaining most attention. If you waste much of your time worrying about questions that can't be answered, you are spending less time on the few things you can answer.

Contrast this with the investment process of Warren Buffett and his partner, Charlie Munger. Their record is astounding, yet they have no analysts on staff to crank out spreadsheets or discounted cash flow valuations. How can two people out-research a staff of 100 highly trained financial analysts using the latest and greatest computer technology?

The answer is that Mr Buffett and Mr Munger are able to filter out the noise better than just about anyone else. Based on the shareholder letters Mr Buffett has written, it appears he does not get distracted by unanswerable questions and daily noise, at least to the same degree as everyone else. He and Mr Munger avoid researching companies they can't easily understand. They ignore questions that can't be answered, such as which direction the economy is headed this year. They don't waste time.

Instead, they focus on just a few things: the integrity and talent of a company's management team, the size of its economic moat and whether its valuation seems reasonable in light of the cash flows it is throwing off today. They don't try to predict the future except in a very general way. They stay within their circle of competence and ignore all else. They don't get distracted by shiny objects - or Bloomberg terminals.