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Michael Mauboussin wrote what I believe is the single best short paper ever written for investors and pretty much everything he writes is insightful, useful and wise. Mr. Mauboussin is a professor of finance at Columbia University, the former head of global financial strategies at Credit Suisse, and previously the Chief Investment Strategist at Baltimore-based Legg Mason Capital Management.
Now with BlueMountain Capital Management, his latest piece is typically great. In it, Mr. Mauboussin details yet another way the human brain is uniquely ill-suited to investing, specifically how poorly we make comparisons between potential investments.
The paper first recounts a pricing strategy used by The Economist magazine where an online subscription was $59, a print-only subscription was $129 and a combined print edition and online access was $125. At first glance the options make no sense but it's actually very clever. The only reason for the $129 option was psychological manipulation – it made the $125 print plus online subscription look like a bargain, and it worked to increase sales.
It's not difficult to apply this tendency to individual stock pickers. Consider a hypothetical situation of three stocks. One has an attractive price earnings (PE) ratio of 10 and an earnings growth rate of six per cent, a second with a PE of 40 and profit growth rate of eight per cent, and a third with a PE of 42 and an annual earnings growth rate of 35 per cent.
The third option looks most attractive compared with the other two, but it still has a PE ratio roughly double the benchmark, and it could very well be a terrible investment overall.
Mr. Mauboussin's report goes on to discuss more ways that, unless we pay close attention, mistakes in comparing investment options are likely.
The reflexive but mistaken use of analogies is discussed using the example of the early days of aeronautics, "The obvious analogy [to human flight] is birds or, more accurately, animals with wings and feathers… The intrepid humans who sought to fly pursued a logical strategy. They fashioned wings covered with feathers, attached them to their arms, went to a high spot, jumped, and flapped."
The analytical techniques to combat these harmful thought processes is discussed at length. They involve a combination of multiple analogies (to avoid relying on just one, which is what most of us automatically do), ranking different asset characteristics at the same time (simple example here) and a more intense method called 'feature-based models.'
I continue to believe strongly that successful investing is much more a matter of how to think than what to think. As a highly respected expert in what makes up a successful investing approach, and the psychological hurdles that we must overcome to develop one, Mr. Mauboussin's work is -- to me -- essential reading.
-- Scott Barlow, Globe and Mail market strategist
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Stocks to ponder
MAG Silver Corp. (MAG-T). The stock has potential near-term catalysts – a soon-to-be released Feasibility Study along with exploration results. Analysts have positive expectations for the stock with a unanimous buy call and a consensus target price that suggests a potential one-year return of over 50 per cent. Headquartered in Vancouver, B.C., the company is an exploration and development silver mining company with a focus on advancing its 44 per cent owned high-grade silver project located in Mexico along with its joint venture partner Fresnillo Plc that owns 56 per cent -- its Juanicipio Property. Jennifer Dowty reports.
Linamar Corp. (LNR-T). This stock may appear on the positive breakouts list sometime in 2018. The stock trades at a reasonable valuation with room for multiple expansion. Guelph, Ont.-based Linamar is a global manufacturing company serving the automotive and industrial markets. Relative to its historical levels and to its peers, the stock is trading at a reasonable valuation on a price-to-earnings (P/E) basis as well as on an enterprise value-to-EBITDA basis. For instance, according to Bloomberg, the stock trading at a P/E multiple of 7.9 times the consensus 2018 estimate, below its three-year historical average of 9.2 times. Jennifer Dowty reports.
The Rundown
Why stock investors need to be nervous about bond markets in 2018
It's a simple fact that all else being equal, a company's profitability improves in accordance with how cheaply it can borrow money from investors in corporate debt markets. The steady decline in borrowing costs in the postfinancial-crisis period has allowed companies to refinance debt at cheaper rates (providing immediate improvements in the bottom line), in addition to buying back shares and funding acquisitions. Borrowing costs, however, are likely as low as they're going to go and set to move higher in the latter half of next year. Scott Barlow explains.
Gordon Pape's fearless market predictions for 2018
It would be great to see a repeat of 2017 in the new year. And we may start off that way as the impact of U.S. tax reform starts to affect corporate bottom lines in the first quarter. Gordon Pape takes a look at what he expects from the markets in 2018.
David Rosenberg: How to approach investing as 2018 gets under way
It certainly was a banner end to an eerily tranquil year for the equity market. Deficit-financed tax cuts filling up all the stockings. At the same time, it is equally interesting to see other markets such as Treasuries and the trade-weighted U.S. dollar index view the economic policies in the United States so radically differently than the stock market. Both bonds and the currency market understand that much of this tax stimulus will be saved rather than spent due to the current sky-high levels of deficits and debt outstanding. David Rosenberg takes a look at the year to come.
Canada's advisers reveal their best suggestions for managing your money in 2018
The people who have seen you naked, financially speaking, have some ideas about how you can better manage your money in 2018. Financial planners and investment advisers in Rob Carrick's LinkedIn network were asked a few weeks ago to complete this thought: "If I could change one thing about how Canadians manage money, it would be to…" Here are some highlights from 199 comments covering a great range of topics, starting off with overspending and undersaving.
The best and worst performers in a 'breakout year' for Canadian IPOs
A robust year for Canadian initial public offerings was, on balance, a mixed one for the Canadians who invested in them. PricewaterhouseCoopers, in its annual survey of IPO activity, reports 38 Canadian IPOs, across all exchanges big and small, hit $5.1-billion in 2017, a five-year record. It's quite the contrast from 2016, where eight issues raised just $464-million. David Milstead takes a look at the Canadian IPO market last year.
How a soaring stock market puts investors under the gun
The U.S. stock market is trading at sky-high levels. So, you've gotta ask yourself one question. Do you feel lucky? Well, do ya? Norman Rothery explores that question, plucked from Clint Eastwood's lines from his 1971 movie Dirty Harry. Problem is, traditional valuation metrics point to bubbly conditions for U.S. stocks.
What a value approach says about FANG stocks right now
It is tempting for value investors to focus on tangible assets because they can kick the tires and visit the factory to check on management, but the real goal is to buy a company below its intrinsic value, which may not be dependent on physical assets. In fact, there are simple ratios that a value investor can calculate to see if a company has been investing to build an intellectual property "moat" around its product offering. We can then form a judgment as to whether or not we are overpaying for these intangible assets. Robert Tattersall explains.
Here's a good, sound portfolio of ETFs that will cost you less than last year
Every year, Rob Carrick takes on the challenge of building a good, sound portfolio of ETFs that costs less than the previous year's. The exchange-traded fund sector delivers the low fees needed to make this happen, and what started in 2015 as the Freedom 0.15 Portfolio has morphed into Freedom 0.11 for 2018. That's 11 cents in fees for every $100 you have invested. Here's Rob Carrick's portfolio suggestions.
How to beat the banks on GIC rates
There is no end to the indignity of being a conservative investor these days. To start, rates on guaranteed investment certificates are ultralow by historical standards. Adding to the pain is the fact that GIC issuers have barely responded, if at all, to the rate increases initiated by the Bank of Canada in the second half of last year. One way to fight back as an investor is to use a deposit broker. Rob Carrick explains.
Top Links
Strong jobs data, interest rate hikes, and problems for dividend investors
The solar power revolution is way over-hyped
Pessimism getting high in marijuana sector
Others
The week's most oversold and overbought stocks on the TSX
Friday's Insider Report: Companies insiders are buying and selling
Thursday's Insider Report: Companies insiders are buying and selling
Wednesday's Insider Report: Companies insiders are buying and selling
Red-hot market rally still has room to run: Merrill-Lynch
U.S. dollar's weak 2017 poses risk of an unexpected 2018 rally
Global factory boom sends commodities prices soaring
How much can buybacks rise on tax cuts? This estimate says 70%
Bitcoin loses dazzle as second-tier 'altcoins' catch up
Number Crunchers
Seven Canadian resource stocks best positioned to rally
The top performers of 2017 inspire the template for this portfolio
Ask Globe Investor
Question: Why would anyone buy a mutual fund? Do the math -- 3-per-cent inflation plus 2.5-per-cent management fee plus 1.5-per-cent maintenance = 7 per cent. So for me to "get ahead" I have to buy a fund that exceeds 7 per cent a year. Of the thousands of funds out there just how many exceed 7 per cent? It would seem that only someone stupid would buy a mutual fund. Or, is there some thing I am missing?
Answer: What you are missing is some accurate math. For starters, inflation is not running at 3 per cent or anything near that. The October annualized inflation rate reported by Statistics Canada was 1.4 per cent. Second, you have added a management fee of 2.5 per cent to a "maintenance fee" of 1.5 per cent, for a total of 4 per cent. There is no such thing as a "maintenance fee" as such. You need to look at the fund's management expense ratio (MER) for the total percentage of all fees and taxes. For an equity fund, that is usually in the 2-per-cent-3-per-cent range, although there are some that are cheaper. A fixed income fund will typically have an MER of 1 per cent to 2 per cent.
Let's assume an equity fund with an MER of 2.5 per cent. Add inflation and you need an annual return of 3.9 per cent to break even by your standards. How many Canadian equity mutual funds achieve that? I did a Globefund search for five-year returns that resulted in 627 hits. These aren't all individual funds – many are different series of the same fund. But it gives you an idea that a lot of mutual funds meet your criteria.
But here's another point to consider. Fund returns are calculated after all fees and expenses have been deducted. So really you only have to beat the inflation rate to come out ahead.
--Gordon Pape
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What's up in the days ahead
Struggling to understand bitcoin and its investment possibilities? Ian McGugan will clear the air and point out the cybersecurity's four glaring flaws in Saturday's Globe Investor.
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Compiled by Gillian Livingston