This column was originally published on RealMoney on Sept. 23 at 12:47 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.
Often investors, both professional and amateur, will run across what seems like a great investment idea in the media and run to act on it. My advice is simple: Wait. For months, perhaps.
I'll lay out my approach to media touts, as well as a list of current stock tips, later on. But first, let's see how the market reacts to them.
Say that the idea is to go long on a stock. At the market open after the story appears, a rush of orders will push the stock's price higher. Then, as the day progresses, the stock will drop and end the day lower than at the open, but usually higher than the prior close.
For the first few days, the market responds to the supply/demand imbalance, and then the merits of the investment become clear. As Benjamin Graham observed, in the short run, the market is a voting machine; in the long run, it's a weighing machine.
My experience has been that after the initial supply/demand imbalance period, the performance of media-touted investments are marketlike on average, leaving the early buyers with assets that generally underperform.
The degree of underperformance varies with the size and character of the audience that saw the story. In general, the larger the audience, the larger the reaction.
The reaction also tends to be larger the lower the experience level of the audience (as long as there is some investment experience -- people with no experience won't do anything). Novice investors are the ones that jump at ideas that seem to be hot when under the media spotlight. Experienced investors tend to have their own idea-generation processes; they either ignore the idea or throw it into their process for later review.
Naturally, the bigger the media play, the bigger the splash. A front-page article makes waves; a tidbit mentioned in passing should have no impact, even though it might be powerful information in the hands of an informed investor. The impact is also greater depending on the fame, or perceived skill, of the source.
The potential size of the investment is negatively related to the degree of underperformance. A positive article on General Electric will have less impact on the price of GE than a similarly positive article on a smaller company. Naive investors place their market buy orders without thinking through the degree of liquidity of the investment.
Know Your Enemies
A number of media sources are particularly given to sensationalism, such as newsletters, online message boards, radio and sometimes television. The risk is particularly great when the "expert" speaking has an ill-defined financial interest in the idea under discussion.
The higher the level of emotion employed, the lower the level of humility, and the less the focus on what could go wrong, the more you should be skeptical. The adviser can sometimes be an enemy of wealth creation.
There are other enemies as well: sophisticated traders who watch for unusual trading activity off of media play and take a short-term contrary position. They short into bullish news and buy bearish news when they perceive that the money acting quickly on it is naive.
What to Do
My advice is simple: Wait. Invest in a subset of the ideas that still have value and have not fully reacted to the information after a period of time.
Also, compare new ideas as a group vs. each other and against the existing assets in your portfolio. Only add a new idea if you think it will beat the median idea in your portfolio. I have detailed these ideas in a piece titled "
Become a Smarter Seller." I usually wait one to three months after I get an externally generated idea before I consider acting on it. I rank new ideas against my current portfolio and choose new ideas based on a mosaic of different factors -- mainly cheapness, momentum (or anti-momentum) and industry exposure. I consider selling positions more expensive than the current median idea in my portfolio, and buying ideas that are cheaper than the current median. The following decision/reaction grid helps explain my actions:
There is a cost to waiting: Some ideas get away from you. This is called implementation shortfall by some. I say you can't kiss them all.
However, waiting has the positive effect that with the passage of time, some investment proposals are proved wrong. Missing wrong ideas is a real benefit for any investment program. Also, waiting takes some of the emotion out of the decision-making process, which helps to avoid errors.
After the waiting period, I ask whether the underlying investment thesis is still valid and whether that is reflected in the current stock price. The media piece that generated the initial interest is long since forgotten, so the emotion and excess stock price moves are gone. But the value might still be there, and with enough new investment ideas, some of them will present real opportunities for above-average investment returns.
Lest This Be Purely Theoretical
I maintain a "B list" of securities that might be interesting investments but don't meet my criteria at present. Here's a list of securities I don't own that are cheaper than the median cheapness estimate of my portfolio. Have a look; maybe you'll find one that interests you.
This article is Part 4 in a series on using investment advice. In earlier installments, I discuss
understanding the adviser,
understanding yourself and
understanding the advice itself.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Agree Realty, Bedford Property, Feldman Mall Properties and Terra Nitrogen to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
P.S. from TheStreet.com Editor-in-Chief, Dave Morrow:
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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he appreciates your feedback;
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Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.
Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.