Good afternoon ladies and gentlemen and welcome back to Behind the Wall. Week four is upon us and I am proud of myself for not letting this devolve into a stock research newsletter yet. Some have expressed that they want to hear more about stocks, but I want to approach this topic carefully. I really don’t want this to turn into a weekly research report. I’ve been really enjoying the casual nature of this newsletter so far and I don’t want writing this to feel too much like work.
With that being said stocks are my first love and I certainly don’t want to avoid the topic. I will probably write about specific stocks in the future, maybe I will even take requests on stocks that you guys like. Let me know if that is something you would be interested in down in the comments.
For now though, I will broach the subject of investing more broadly to ease our way into the more mathematical side of finance. In particular, I will be describing my philosophy on investing and give a high level overview of different investing approaches. Before I get started, I want to reiterate, I am not a financial advisor and you should not be taking this article as advice on your own investment strategy. If you try to sue me, I will laugh at you and probably write a newsletter making fun of you.
Value Investing
Warren Buffett always says “Be fearful when others are greedy and greedy when others are fearful”. I say, “Warren Buffett is a nerd”. No, I don’t actually say that. Buffett is probably the greatest investor of all time and I would never say something like that about him (to his face).
I agree that value investing, buying stocks of companies whose cash flows justify a higher stock price (undervalued stocks), has a place in finance. My career in finance began at a fundamental analysis, value based equity research company and it has since been ingrained in my investing DNA. However, value investing has its downsides. All of the fundamental money managers and research institutions have been saying that Tesla (NASDAQ: TSLA) has been “overvalued” for at least 5 years. But if you had invested in Tesla in March of 2019 your investment would be up nearly 850% and that includes the stock tanking over 25% so far in 2024. This compares to an increase of 84% if you were invested in the S&P 500 (the market) over that same time period.
Does this mean value investors were wrong about Tesla being overvalued? Yes and no. They were correct in assessing the fundamental value of the company based on its (then) current and projected financials. They were wrong if they considered the fundamental value to be the stock’s target price.
Clearly the market has disagreed with value investors on Tesla’s stock price over the past five years. This usually happens when the fair market value (what someone is willing to pay) is higher than its intrinsic value (what it is actually worth). We see this in many aspects of life. How many of you have a sentimental object that you would be unwilling to sell? Some of the most glaring examples of this are NFTs (non-fungible tokens). These were all the rage in 2020 - 2021 and people were paying millions of dollars for them. They were digital pictures (some might call them art) that theoretically were unique (although I could just take a screenshot of them). These, I would argue, have no intrinsic value and their entire value comes from what speculators (gamblers) were willing to buy them for.
Value investors try to find the opposite of what I just described above. They try to find investments where the intrinsic value is currently higher than the fair market value of the investment, believing that the market will eventually catch on and drive the value of the investment up.
Value investing has been the only strategy that has been consistently profitable in any economic and market condition. If I was going to recommend an investing strategy (which I am not) it would be value investing. The reason that I won’t recommend it is because it would be nearly impossible for you to consistently find companies that are truly undervalued and be willing to hold them long enough to realize the return. Many companies, like Warren Buffett’s Berkshire Hathaway, spend billions of dollars to find these undervalued companies and invest in them. I promise you, the market is already aware of 99.99% of the information that you can find. Unless you are doing it as your full time job, it makes more sense for you to invest in Berkshire Hathaway than to do the work yourself.
I know I just described value investing very positively but there are some downsides as well. The main downside is that it takes a long time to realize returns. Not only do you have to be right, but you might not even find out if you were right for many years. Another downside is that you give up very high returns in the short term (like the Tesla scenario above) for long term consistent gains. Are you willing to give up 850% return in 5 years for 20% return per year for 30 years? These are some of the tradeoffs.
Personally, I think the time that value investing offers the most benefit is in a stagnant or recessionary environment. In a downturn, the value of stocks typically moves toward their fundamental or intrinsic value. This means that Tesla’s stock will decline and an undervalued stock will rise. Value investing is one of the few profitable investing strategies in a recession.
I don’t want this newsletter to be too long so I will go through a couple more strategies more quickly.
Event Driven Investing
This strategy is one of the most interesting and also one of the hardest. It involves trying to predict market events and their downstream impacts. If you think a company is an acquisition target, it is probably a good investment. If an acquisition is announced it will likely generate large profits in a short amount of time.
A good example of event driven investing was right after the Hawaii fires in 2023. Even before the fires had been put out, investors began guessing who was responsible. Short sellers bet against stocks of companies that could potentially be liable for the fire. When Hawaiian Electric (NYSE: HE) was implicated as causing the fires through faulty power lines, the stock dropped over 60% in a week and some investors made fortunes.
Obviously, the investors who practice this strategy are often criticized for caring more about profits than about people, as a large portion of event driven investing is betting against stocks as opposed to investing in a company’s growth. But as I mentioned in a previous newsletter, capitalism often rewards the greedy, and if you are very good at predicting the effects of everyday events in the world, this can be a very lucrative strategy.
I do not generally recommend this strategy to everyday investors for similar reasons as I mentioned above, but this is a strategy that can be lucrative if you become an expert in the industry you work in. If you are tuned in to the events that make your industry tick, then it could be easier for you to know acquisition targets in the industry, or know what events would lead to change. I will caution that trying to guess the market is generally unprofitable unless you truly are an expert. As a side note, this only applies to your industry as a whole. If you trade this way on the company you work you could go to prison for insider trading.
Even if you are not going to employ this strategy with your money, it is a good exercise to look at events that occur around the world and think about the causes and, usually more importantly, the effects of those events. If you find that you can accurately predict the sectors or even the individual companies that will benefit or be hurt by said event, you might be ready to invest using this strategy.
Here is a good exercise to leave you with. What is the biggest impact that the war in Ukraine has had on financial markets? Most people would probably say a benefit to the defense industry. I would argue that because of the war, you would have made more money investing in corn.
Momentum Investing
This strategy has caught on in recent years among everyday retail investors. The most extreme example of this was in early 2021 when GameStop stock (NYSE: GME) exploded, increasing over 1,600% in a matter of days. Part of the reason the gains kept increasing was that investors were scared to miss out on making money, so they joined in hoping to profit along with everyone else.
This strategy is generally only good for the investors who get in early, that is, before the dramatic increases begin. While it is true that you could make some money if you get out of the investment soon enough, more than likely you will still be there when the stock comes crashing back to earth. Just as the GameStop gains came in a few days, it only took a few more for the stock to crash over 90%. There were many people who were just trying to ride the wave of momentum to an easy payday that lost everything on this one trade.
While this is an extreme example, the general idea of this strategy is the same. Right now, “the big thing” in investing is artificial intelligence. Every stock that is remotely connected to AI has increased triple digits over the past year. While disciplined value investors might be able to resist the temptation of those gains, most retail investors cannot.
This strategy can be very lucrative if you are careful. One thing that needs to be ingrained in every investor is that it is impossible to time the market. No one knows when a downturn will begin or when AI will fall off and there will be another “big thing”. It is hard to miss out on riding momentum but you need to have a backstop. If you are going to apply this strategy you need to familiarize yourself with stop-loss trades and other forms of hedging. Do not enter any trade without a plan; know before getting in when you plan to get out.
Technical Investing
I won’t spend much time on this strategy as it is something that I do not believe in. With that being said, I have some friends who swear by it and they have some data to back it up so I might as well mention it. This strategy relies on technical analysis, which is essentially looking at charts. When you study stock charts you can learn some valuable information from them. For example, if there is a spike in trading volume for no apparent reason that is something to look into. However, a lot of this analysis involves finding patterns in the movement of a stock and using previous stock charts to predict where the stock will move going forward.
The problem is that, just like gambling, the charts are essentially random and past performance has very little to no impact on the future results. As humans, our brains are hardwired to look for patterns. It is easy for us to see shapes in clouds but that doesn’t mean that seeing a turtle shaped cloud indicates that it will rain tomorrow, even if you saw one last week and it rained the next day.
The one reason that this strategy has some credibility is that many high-frequency quant traders (computers that automatically make trades for you) are based on technical analysis. There is some merit in resistance levels and “trading bands” that a stock will move between for a while. However, this is usually a self fulfilling prophecy, as the computers will sell stock when it hits the “ceiling” driving the price down and then buy it back when it hits its “floor”. This artificially creates trading bands.
If you want to employ this strategy, do so at your own risk. I will have no part in it.
How I Invest
I like to think of myself as a pretty good investor. That or I have just been very, very lucky in picking stocks over the past four or so years. I am aware that the markets have generally been positive over this time frame so everyone is probably up. As of the time of this writing (March 5, 2024), the S&P 500 is up 57% since January 1, 2020, so clearly most people are doing pretty well with their investments. I really don’t mean to brag but I have beaten the market every year since 2020 and am currently up 180% year to date. I am able to do this through a combination of investment strategy and risk tolerance.
I know that my portfolio management professor would have an aneurysm if he knew this, but I am currently only invested in two individual stocks. This breaks the most important rule of portfolio creation, which prioritizes diversification over everything else.
The reason I do this is to follow a very simple principle in finance, the greater the risk the greater the reward. With my portfolio concentrated in only two stocks I reap greater reward if the stocks do well and I lose a lot more if they do not (as compared to investing in the S&P 500). I am willing to take this risk for a few reasons. First, I am young and the younger you are the more you should be concerned about growing wealth as opposed to preserving wealth. Secondly, I am very confident in the stocks that I pick.
The way I pick stocks is probably not unique but it works for me. My overall strategy is a mixture of all strategies mentioned above (except for technical analysis). I use a top-down approach to the economy and the stock market as a whole. First, I look at the economy and try to gauge the way the wind is blowing. I try to narrow down the sectors that will benefit the most from the current state of the economy and where consumers are spending the most money. I am constantly on the lookout for macro events that will change the status quo.
Once I narrow down my search to one or two sectors, I dive into the major players in that market. I look at who has the best margins, the best technology and maybe most important of all, I look at who holds the pricing power in the industry. Ideally I would like to find stocks that are undervalued, but in a strong stock market cycle like we are in now, I prefer momentum stocks. With that being said I have some stocks that I believe are undervalued that I invest in if I feel the stock market is moving toward a downturn.
Once I pick which stocks I want to invest in, I come up with a strategy to buy them and when and how I will sell them. These strategies can vary depending on where I think the stock is moving. Generally I will watch a stock trade for anywhere from a few weeks to a few months or more before I enter a position, trying to enter at the lowest point I can. I employ stop-loss trades consistently, constraining my downside risk using a ratchet strategy where I move my stop-loss price up as the stock increases in value. Generally, the stock will automatically sell if I lose 10% from the most recent high. I set a limit of how much I would like to gain on a stock before getting out. As a general rule of thumb, if I go up 50% on any stock I will exit. Being too greedy is how you lose all of your gains in this business.
I am probably not going to mention which stocks I own right now because I really don’t want to feel responsible if you buy them and lose money. I am pretty good about telling my friends which stocks I like, but I am not as consistent with telling them when to exit. But I will say that the sector I like right now is AI adjacent. I like companies that are upstream of the final products and that create technologies that allow for AI to be developed. Why bet on a single AI developer when I can invest in a company that all AI developers use?
How You Should Invest
I will end this by quickly mentioning my recommendation for your investment strategy. Obviously I do not know all of you individually or your current financial position or risk tolerance. But honestly it doesn’t matter. You should be invested in the market. Unless you work in investments and know exactly what you are doing, you should invest in the S&P 500 (the most diversified stock index) and maybe some bonds, but that is it. If you are working in investments then you probably can’t be trading individual stocks anyway, but for retail investors, I urge you to not invest in individual stocks. For most of you, buying individual stocks is the same as gambling. If you have a little bit of play money and want to mess around with it then sure, invest in a company that you believe in. But please, do not gamble your life savings in the stock market. Every study has shown that in the long run, no one beats the market, so do not try.
Finally, I know that some of you are probably disappointed that I am not giving you stock recommendations. There is a possibility that I will post and update my portfolio weekly going forward. But right now I am still wrestling with the pros and cons of that and the responsibility I will feel if someone loses a lot of money.
I would like to say thank you to everyone who is still reading these every week and I am asking a little more of you this week. If you like Behind the Wall and want to see it continue I need your help spreading the word. It would mean the world to me if you could share Behind the Wall with your friends and colleagues and hopefully we will continue to grow together.
Read more from Behind the Wall
Week 1: The Best Thing That Ever Happened To Me: Being Laid Off
Week 2: The Case for a Recession
Week 3: Creating the Narrative: How to Lie With Statistics
Thank you for reading!
Great job! What is Tesla’s theoretical target price?