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Behind the Numbers

The virtue of simplicity Add to ...

Norm Rothery is a little bit simple and doesn't mind admitting it.

Mr. Rothery, who holds a PhD in physics and the Chartered Financial Analyst designation, is far from dim. (I've counted him as a friend for years and can attest that he's one of the brightest individuals you'll ever meet.) But the publisher of the Rothery Report investment newsletter is a big believer in the virtues of simplicity when it comes to picking stocks.

Over the past few years, he has outperformed the market with techniques that seem painfully obvious. He believes that most investors can improve their stock-picking by starting with short checklists of the factors they want in their investments.

"Complexity isn't necessarily a good thing when it comes to picking stocks," he says. "The real challenge is sticking to the stocks you like and not getting scared out of them if they don't work out immediately."

If you're looking for a New Year's resolution for 2011, ponder Mr. Rothery's words. After the ups and downs of the past three years, many investors have convinced themselves that investing is a dark art, open only to those who can probe the mysteries of the global gold market or the financial intricacies of investment banks.

The problem, of course, is that most investors aren't up for that challenge. But rather than throwing up your hands in frustration, you may want to take refuge in what you do know.

Numerous studies demonstrate that simple factors can predict investing success. For instance, Kenneth French, a professor at Dartmouth College, has found that low price-to-earnings stocks and low price-to-book stocks regularly trounce the broad market.

So why do so many investors ignore these attributes and look instead for stocks with a charismatic CEO or a compelling story? It's all about psychology. James Montier, a member of the asset allocation team at the money manager GMO, has explored the mindset of investors in an essay entitled "Keep It Simple, Stupid," in which he examines research into how people arrive at decisions.

A key finding is that people become more confident in their choices as they accumulate more information. Strangely, though, their decisions don't become any better.

In one study, people were asked to choose among four cars. The first group was given four pieces of information about each car; a second group was handed 12 pieces of information.

In both groups, the information clearly indicated that one car was the best - but as the amount of information went up, people's ability to choose the best vehicle fell. While 60 per cent of people chose the best car when given four features, only 25 per cent could spot the top vehicle when handed 12 attributes.

Much the same happens with stocks. Turn on the television or surf the Web and you're inundated with information about the market. But that access to information hasn't made people better investors.

A better approach, says Mr. Rothery, is to highlight a handful of factors, then look for stocks that meet those criteria. Want value? Then look for stocks trading at low price-to-earnings multiples (say, 10 or less). Want safety too? Then cut your list of low P/E stocks down further, selecting only those that have less debt than equity.

That, in fact, is how one of Mr. Rothery's most straightforward stock selection techniques works. It's based on the Simple Way method invented by Benjamin Graham, the famed investor, who found that selecting stocks on the basis of only two similar criteria regularly produced returns of 15 per cent a year.

Mr. Rothery's own Simple Way portfolio of Canadian stocks has only a year-and-a-half of history, but it produced a stunning 70-per-cent return in the year ended in December. (In case you were wondering, current inhabitants of the portfolio include Research In Motion, Nexen and Transcontinental.)

Mr. Rothery rushes to caution that his recent results aren't typical. He adds that any strategy will select some stocks that disappoint (which is why you should have a diversified portfolio with at least 10 stocks in it). And any portfolio will have periods when it lags behind the market.

But with those caveats in mind, it's clear that simple strategies can still succeed in today's market. At the very least, Mr. Rothery says, insisting that all your stocks meet a simple checklist of two to five factors allows you to quickly winnow a market of a thousand or more names down to a relative handful of possibilities. And knowing exactly why you've selected a stock can give you the confidence to stick with it in bad times. As we head into 2011, maybe you too should think about becoming simple.

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Follow on Twitter: @IanMcGugan


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