Double Jeopardy: Avoid Asking the Wrong Questions

Anybody can make money in a raging bull market. Thought processes can be flawed, and sloppy analyses can still result in gains. There isn't even a lot of luck required to make money in the context of a bull market.

Tough markets, though, like the one we're in, are the great illuminators. You can't hide: The floodlights burn bright. Poor analysis is punished severely, and a clear line of demarcation separates the successful from the unsuccessful.

One key to superb investing against a tough market backdrop is to avoid the errors made by the consensus. If you march lockstep with the crowd, your returns will mirror the market. In a mediocre-to-poor market, your rate of return will be mediocre to poor. But if you think differently, against the grain, and avoid asking the wrong questions, you have a chance to succeed.

Here are a few of the wrong questions I consistently hear investors ask. These shouldn't be asked at all.

What is the current price-to-earnings ratio ?

Earlier this year, I received an email from a reader who lambasted me for several of my picks, claiming that their current P/E ratios were too high. If I had a top-100 (maybe even a top-1,000) list of items to review concerning stocks I was considering for investment, current P/E wouldn't make the list, especially in the throes of an economic downturn.

When I analyze a stock, my analysis is always forward-looking. I want to know what a company can earn in a year or two or three. It's called anticipation, trying to identify changes before they occur, with the objective of getting in position ahead of the change.

Consider my current enthusiasm for airline stocks. The P/Es are sky-high in this sector, with almost every conceivable operational head wind depressing current earnings. When better times arrive -- and they will -- earnings will jump and P/Es will become respectable again. Of course, that's when I'll be selling.

What is the debt-to-capital ratio?

This sounds like a sophisticated question, and it's bandied about by most Wall Street analysts. But I have found the debt-to-capital ratio to be an almost useless data point because stated capital is generally misleading for most companies.

I have to make a series of capital adjustments for virtually every company I look at. As the multibillion-dollar write-offs at Lucent and Cisco demonstrate, the capital on the books at many companies is nothing more than a chimera. At other companies, such as J.C. Penney, the capital is grossly understated.

What is the analyst rating?

The furthest thing from my mind when assessing the viability of an investment in a particular stock is the analyst rating. The analyst mind-set on Wall Street is singularly linear. Unfortunately, the way to make money is to recognize the cyclical nature of every business and to anticipate changes in those cycles.

What are the positives in this stock?

My first question is the flip side of this one: Jaded analyst that I am, I want to know all of the negatives about a stock. To the extent that investors want positives on a stock, they should look beyond products, management, market position, etc., and consider one of my favorite "positives" that is common among the stocks in my portfolio: Business stinks!

The stock has gone down. What's wrong?

Stocks go down. Sometimes it has nothing to do with the underlying business. It could be an institution overhauling a portfolio, and the subsequent selling pressure causes the stock to decline. It could be any number of things that have nothing to do with the underlying business; it could be a rumor, profit-taking or a result of a weak overall market.

What was the average performance of this fund for the past five years?

Everybody makes money in a raging bull market, so determining managerial competence is problematic in an upswing. I'd even take it a step further, with a position supported by data from the last cycle: In general, the best performers in a bull market are not the best managers.

In the last bull cycle, the best performers took inordinate risk, often buying companies at 80 to 100 times earnings, compromising all reasonable valuation standards in pursuit of return. This is much closer to incompetence than it is to competence.

The only way to ferret out incompetence and the high-risk takers is to assess performance in tough markets, when only a few money managers can figure out how to make money.