Most investors spend very little time thinking about portfolio management. Individual investors tend to trade their portfolio based on news flow, tips and price action. They use price targets and stop losses to buy and sell stocks in their portfolio. This tends to create a lot of activity in the portfolio and is one of the leading causes of retail investor underperformance. Academic research indicates that poor portfolio management and over trading are among the leading causes of investor underperformance.
Focus on the Business, Not the Price
In his classic 1972 book 100 to 1 in the Stock Market, author Thomas Phelps tells the story of a businessman who sold his companies and invested the proceeds in the stock market. He told Phelps that it was driving him crazy to watch the fluctuating stock prices every day. The stocks he bought went down and the ones he didn’t went up, and the whole experience was causing him sleepless nights. Phelps asked him how he evaluated the companies he had owned before he sold them. The businessman said it was simple. As long as sales were rising and profit margins were good, he knew the business would be fine and it didn’t cause him a moment’s concern. He couldn't see a price for the businesses every day, so he focused on how the business was performing and not the current price.
Phelps suggested he manage the stock portfolio the same way by focusing on the quarterly reports and the progress of the business and ignore the daily price fluctuations. This would allow him to achieve similar results and peace of mind. The businessman said he couldn't. The information was available, and he felt compelled to check the prices every day. (This was before the Internet and smartphones allowed you to check prices every minute, and the only reliable source of information was the Wall Street Journal.) (See also A History of Wall Street Profitability.)
Investors would be wise to manage their portfolios in the way Phelps suggested. Every quarter companies release their financial information, and investors should focus on what's going on with the business and less on the day-to-day price fluctuation of the stocks they hold. A longer-term focus with less activity should lead to higher long-term returns.
It's All in the Numbers
Each quarter investors should read the earnings release of their holdings and ask some basic questions. Are sales growing? If not, why not? Are earnings higher than they were in the previous quarter and 12 months ago? Again, if not, why not? Has the company issued new shares of stock or increased debt levels? If so, what was the purpose of the offering, and how will the funds be used? Are there new products or services being released that could drive sales and earnings growth? All of these questions are answered in the earnings release and subsequent conference call. Investors should read the release and the transcript of the call and ask a series of question that determines how the business is doing.
Since everything else in the financial statements ends up being reflected in the shareholders' equity, it's important to determine if the book value per share is growing as fast as reported earnings. If it's not, then you need to know where the money is going. If it's being spent on research and development, that’s potentially positive. If it's disappearing into higher selling general and administrative expenses, that’s a red flag indicating management is unsuccessfully reinvesting profits in the business. Over time book value per share should be growing at least as fast as reported earnings.
Management's Attitude Matters
Investors should also examine management's attitude towards shareholders. Is the company paying a dividend? Has it been increasing over time? Are the buyback shares of stock to increase the value of remaining shares? Are they doing so at reasonable valuations, or are they buying overvalued shares to temporarily inflate earnings per share? If they're buying back shares of stock, is the number of shares outstanding, or is it offset by stock options and stock grants to management? Are any officers and directors making open market purchases or sales of the stock around current prices? The attitude of management towards shareholders and their ownership and trading activity of the company they own can be a significant factor in considering the future performance of the corporation and the stock price. (See also Get Tough on Management Puff.)
Focus on Long-Term Ownership of Good Businesses
Rather than focusing on arbitrary price targets and daily market action, investors should consider how the business itself is doing. If the company is growing and profit margins are stable, then you can comfortably hold the stock. If the company is doing well and the stock is down, you might want to consider buying more shares. If, however, the business is struggling and you can find no valid reason that it will improve anytime soon, then it's time to think about selling the stock regardless of the current price action.
The Bottom Line
Focusing on the business itself rather than the stock price will lead to long-term ownership and lower transaction costs. The real money in stocks is made by those patient investors who view their holding as ownership of a business and hold their shares as long as business is good.