SOURCE: Disciplined Growth Investors

Disciplined Growth Investors

September 03, 2013 05:00 ET

Disciplined Growth Investors: Investing and the Difficulty of Doing Nothing

Benjamin Graham and the Power of Growth Stocks, 14th in a Series

MINNEAPOLIS, MN--(Marketwired - Sep 3, 2013) - Adhering to an investment strategy designed to provide superior long-term returns requires something that very few brokers and investment managers are willing to try -- long periods of inactivity, according to author Frederick K. Martin of Disciplined Growth Investors.

While patience may be the key to success for long-term investors, inactivity is not considered a virtue in the transaction-driven investment profession. "Taking a buy-and-hold approach and patiently waiting for the perfect time to invest in a stock contradicts the institutional imperative that inactivity is a bad thing," writes Martin in his book, "Benjamin Graham and the Power of Growth Stocks" (McGraw-Hill).

That institutional impatience is driven by both the investment industry and the clients it serves. "Your clients think you're not working for them if you're not making any trades," adds Martin. "They want to know, 'Why should I pay you for doing nothing?'"

While the best money managers are able to resist the urge to trade actively, the pressure can be intense, as Warren Buffett explained: "The stock market is a no-called strike game. You don't have to swing at everything -- you can wait for your pitch. The problem when you're a money manager is that your fans keep yelling, 'Swing, you bum!'"

For transaction-based brokers, the call to action is music to their ears. If their clients want action, with more trades and more transactions, their broker is more than happy to comply. Their livelihood depends on it.

In fact, the brokerage industry has even come up with some effective tools to encourage even more trading among their clients:

Story stocks. Brokers like to pitch "story stocks" -- companies with an intriguing story behind them. The company may be launching a new technology, a new medical device, an exciting new service, or a marketing campaign intended to boost the company's bottom line. Whatever the story, clients are often eager to hear about the next big thing, and just as eager to throw some of their investment dollars at the stock. "What the stock is actually worth is irrelevant," says Martin. "If there's a good story behind it that finds its way to Wall Street, investors often plug the stock into their portfolios to see what happens."

Target prices. Target prices refer to a recommended price that brokerage firm analysts suggest for investors to sell a given stock. The concept is to encourage an investor to buy a stock at what the analyst considers a favorable price and hold until it rises to the "target price" set by the analyst. So you might buy a stock at $20 with a target price of $25. When it gets to $25, your broker will urge you to sell the stock and buy something else. On the chance that it stalls out and fails to reach the target price, your broker will, no doubt, urge you to sell anyway and try a different stock with a new target price.

"There is no magic to these target prices," says Martin, "and there is no real reason to sell a stock when it reaches a target price. There's no evidence to suggest that selling a stock at a target price and reinvesting in another stock is a good way to improve your returns. In fact, there is plenty of research that would suggest just the opposite."

So what's the value in target prices? "The real target," explains Martin, "is the unwitting client, who is pressured to buy and sell these stocks based on this arbitrary target pricing system."

Target prices have the effect of discouraging investors from thinking long-term, focusing instead on the target price their broker has recommended. "The target price process actually divorces the investor from the company of the underlying the stock," adds Martin. "The investor is renting the stocks -- not buying and not building a position in great companies that will pay off with big gains over the long term."

STOCK ANALYSIS AND THE VALUE OF WASTED EFFORT

If you do the proper due diligence on every stock you consider buying, there will be times when you'll uncover some weaknesses in the stock that will convince you not to buy it. While you might consider all the time you've put into researching that stock to be wasted effort, the truth is, the effort required to eliminate a stock from consideration is actually time well spent. As Donald Trump said, "sometimes the best investments are the ones you don't make."

Very often your investment success depends almost as much on what you don't buy as it does on what you do buy.

"We may spend weeks or months evaluating a stock, building a seven-year price projection, and tracking the stock before we ever make a decision on buying it," explains Martin. "And the fact is, in many cases, we may end up deciding not to buy the stock. The price might rise before we're ready to buy, or we might see a red flag when we're evaluating the company that convinces us not to buy the stock."

As an investor, it's important to keep in mind that you don't have to swing at every pitch. In fact, the best poker players fold on 80 percent of their hands. You need to be careful to only buy stocks that make sense for your portfolio over the long term -- and that may mean long periods of inactivity. There is no shame in that.

As you're evaluating stocks, go through a thorough due diligence process, evaluating the financial strength of the company, its competitive advantages and its potential for sustained long-term growth. If the stock doesn't meet your standards, move on. There are thousands of other stocks to consider. Unfortunately, that may mean spending many more hours evaluating prospective investments, but even when you decide that one of those stocks is unsuitable for you, that wasted time will be time well spent.

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