{"id":210317,"date":"2024-08-14T10:15:47","date_gmt":"2024-08-14T14:15:47","guid":{"rendered":"https:\/\/ibkrcampus.com\/campus\/?p=210317"},"modified":"2024-08-15T05:54:08","modified_gmt":"2024-08-15T09:54:08","slug":"humility-matters-too","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/traders-insight\/humility-matters-too\/","title":{"rendered":"Humility Matters, Too"},"content":{"rendered":"\n

Given the recent instability of the market, now is the perfect time to share a universal law that most investors don\u2019t know, but need to know if they want to enjoy any sort of long-term success. It\u2019s a secret I got from my time on Wall Street about the nature of investing. The secret is based on the second law of thermodynamics. Please don\u2019t tune out just because I got super geeky there, I promise you will be a better and smarter investor when you finish reading this letter. You\u2019ll also get free research on 3 mega cap stocks and a link to join our next live podcast.<\/p>\n\n\n\n

I think it\u2019s time to come back to some basic principles about life and investing. First, a little background. The market has been on an incredible run for the last 20 years. Sure, we\u2019ve seen a few downdrafts, but take a look at Figure 1. Tech stocks over the last 10 years have crushed it. Note how small a blip the late 1990s\u2019 tech bubble is compared to the last several years. True, a logarithmic chart of the Nasdaq-100 is probably more appropriate. I looked at that version, and it doesn\u2019t change the message. The market feels a little too good to be true to me\u2026and you won\u2019t hear many other people admit that.<\/p>\n\n\n\n

Figure 1: Nasdaq-100 Performance Since June 1995<\/strong><\/p>\n\n\n\n

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Sources:\u00a0Google Finance<\/a><\/p>\n\n\n\n

Considering the huge amount of both Fiscal and Monetary stimulus poured into our economy over the last 10 years (detailed in a prior letter here<\/a>) , no one is surprised that we have an inflation problem, a very stubborn one. That inflation applies to the stock market, too. I\u2019m sure you could name a lot of other problems as well as some very promising trends.<\/p>\n\n\n\n

But, the one problem we need to keep top of mind is \u201centitlement\u201d. Specifically, entitlement to double digit returns on stocks in the short, medium and long term. Too many investors have grown up in a world where \u201cbuy the dip\u201d literally works every time. They do not care why it works, just that it works. And, they do not care why stocks go up, just that they go up. If you don\u2019t believe me, just ask any meme stock investor.<\/p>\n\n\n\n

The problem here is not that stocks are going up. Many stocks deserve to have gone up and to go up much more. We provide many lists<\/a> of such stocks to our clients. I\u2019m also hosting a live show on August 15, 2024 to show investors how to perform due diligence to find the best stocks \u2013 sign up here<\/a>.<\/p>\n\n\n\n

The problem, as shown in Figure 1, is the disproportionate outperformance of certain stocks, like the \u201cMagnificent 7\u201d. There are too many stocks that have gone up way too much. They are priced for perfection, an impossible perfection according to our reverse DCF models. But, no one else wants to talk about that.<\/p>\n\n\n\n

Unless this is your first time reading my letters, you\u2019re well aware that New Constructs is different from other research firms. We\u2019re in the business of making our clients smarter. We want you to win. And, as I will show below and have shown with empirical evidence in prior letters<\/a>, most other research firms are looking out for themselves not you.<\/p>\n\n\n\n

That fact is central to my message (and secret) today. Wall Street firms and advisors like to make you think everything is taken care of. Perfection is possible. They\u2019ve done their diligence and scrubbed the numbers. Their ratings are reliable. And, they keep telling us that we can trust them when they say perfection is possible even though time and again, we learn that we can\u2019t trust them. Remember this scene<\/a> from the movie The Big Short \u2013 more details in my last letter<\/a>.<\/p>\n\n\n\n

Now, here\u2019s where the second law of thermodynamics comes in. It states that<\/p>\n\n\n\n

\u201cas one goes forward in time, the net entropy (degree of disorder) of any isolated or closed system will always increase (or at least stay the same).\u201d Source<\/a>.<\/p>\n\n\n\n

Entropy is a measure of disorder and affects all aspects of our daily lives.<\/p>\n\n\n\n

The stock market is not immune to the law on entropy or the second law of thermodynamics. Constant work is required to maintain order. Order is not free. Things are changing all the time. Perfection is not possible.<\/p>\n\n\n\n

This law applies to the stock market and every single stock. Constant work is required to maintain good analysis of every single company. Prices change every day, new filings come out nearly every day. Yet, so many financial advisors want to portray the illusion that they\u2019ve got it all under control. You can trust them. They and their firm have so many smart people, and they\u2019ve covered all the bases. They have all the answers, that\u2019s why you should trust them and give them all your money.<\/p>\n\n\n\n

Well, I will be the first to tell you that neither I nor New Constructs have all the answers. That\u2019s impossible. We\u2019re not perfect. We are not right all the time. No one has all the answers. We\u2019re modest enough to admit that. At New Constructs, we understand our limitations, which allows us to also understand our strengths. We will tell you what we can do and cannot do. For example, at 3 minutes and 30 seconds into my CNBC interview last Thursday<\/a>, Tyler Mathisen asks me to explain why the market was down that day. My answer: \u201cmy crystal ball is in the shop.\u201d After giving Tyler and Kelly Evans some very specific answers about Intel (INTC), Meta (META) and Amazon (AMZN), I abruptly refused to pretend I could explain what was happening in the overall market. I made a few jokes at my own expense and noted that trying to explain what\u2019s happening in a market where a character like Roaring Kitty<\/a> can move markets is a fool\u2019s errand. <\/p>\n\n\n\n

Figure 2: Clip from My CNBC Interview<\/strong><\/p>\n\n\n\n

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Sources: CNBC:\u00a0Three Stock Lunch<\/a><\/p>\n\n\n\n

Try finding an advisor or Wall Street insider who won\u2019t take every opportunity to prognosticate on the state and future of the market. They even have a special name for Wall Street\u2019s market prognosticators. They call them strategists. Guess what percentage of them are bullish at any given time? How many research firms have a Zombie Stock list<\/a>?<\/p>\n\n\n\n

Now, as you think about your money and your research, I have a few more questions for you.<\/p>\n\n\n\n

Can you put a price on honesty?<\/p>\n\n\n\n

Can you put a price on humility?<\/p>\n\n\n\n

I think humility is absolutely essential to being a successful investor and analyst. It\u2019s as important to know what you don\u2019t know as what you do know. But, that\u2019s not how most investors think.<\/p>\n\n\n\n

I will never forget the meeting I had with a portfolio manager of a $50+ billion fund back around 2005. After explaining to him what New Constructs offered, he replied with:<\/p>\n\n\n\n

\u201cYour data probably is better. But, as long as everybody\u2019s using the same bad data, I\u2019m OK with that<\/strong>.\u201d Source: Harvard Business School Case #118068<\/a><\/p>\n\n\n\n

Not a lot of humility there. To say he does not care about having the best data means that he believes he can outperform with inferior data. That\u2019s pretty cocky. Either that or he doesn\u2019t care about outperforming. I\u2019m not sure which is worse.<\/p>\n\n\n\n

I\u2019ve had many other similar meetings with \u201cprofessional\u201d investors. It\u2019s not just the sell-side Wall Street folks that should worry you, but the big money managers on the buyside are not always doing their homework either. And, they are so arrogant that they will say out loud that they do not care about diligence sometimes.<\/p>\n\n\n\n

My point is that a big part of humility is recognizing how hard it is to do proper research and diligence.<\/p>\n\n\n\n

Ever notice how we talk about diligence a lot, especially compared to other firms. Other firms would prefer you keep thinking the music will never stop, perfection is possible, and stocks will just keep going because\u2026.well that\u2019s what stocks do.<\/p>\n\n\n\n

Are you the type to believe that stocks will just continue to go up forever? Do you think that fundamentals matter? If you\u2019ve read this far, my guess is the answers to the last two questions are \u201cno\u201d and \u201cyes\u201d.<\/p>\n\n\n\n

We\u2019re very focused on one thing at New Constructs: delivering superior fundamental research. As I\u2019ve mentioned before, there are few signs out there that we are good at what we aim to do:<\/p>\n\n\n\n

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  1. #1 ranked stock picker on Sum Zero\u00a0for 39 months straight<\/a>.<\/li>\n\n\n\n
  2. Three prestigious institutions<\/a>\u00a0published papers proving our research is superior.<\/li>\n<\/ol>\n\n\n\n

    Now, the biggest question I have for you is whether you\u2019re ok with using the same bad data as everyone else?<\/strong><\/p>\n\n\n\n

    Don\u2019t think there\u2019s bad data out there? Let me provide more examples.<\/p>\n\n\n\n

    A recent MarketWatch article<\/a> featured return on invested capital (ROIC<\/a>) research from FactSet (FDS) and allows us another real-time opportunity to compare our research to a competitor\u2019s. On July 16, 2024<\/a>, we highlighted alarming differences between our research and Morningstar\u2019s.<\/p>\n\n\n\n

    As with Morningstar, there are very large differences between our research and FactSet\u2019s. For example:<\/p>\n\n\n\n