Making the Grade

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Can investors learn something from test-taking strategies?

Public Domain. Source: US Navy

It may be close to the end of the year, but it’s also college application season. A lot of high-school seniors are filling out the Common App, writing and re-writing essays, and anxiously awaiting their latest test scores. And there’s a test-taking technique that kids use to improve how they do on standardized tests that can help investors.

It’s called elimination. When they come to a question where they haven’t got a clue, they can improve their scores by eliminating answers that they know are wrong. In a multiple-choice test, someone just filling in the circles gets 20 or 25% correct by random chance. But by eliminating the obviously wrong answers, students can better their odds. They won’t guess right every time, but they’ll do better than if they had left the answer blank.

Standardized Test. Photo: Onderwijsgek. Source: Wikipedia

In the same way, investors can do better by eliminating what’s wrong. If a company’s business model makes no sense — if you can’t figure out how they earn their money –then don’t own that business. If management seems to be more concerned with politics and celebrity than capital investment and human resources, don’t buy the stock. This is a variant of The Loser’s Game by Charlie Ellis. We can do better by avoiding dumb ideas.

For example, in December of 2000 Enron employed 20,000 people and claimed revenues of over $100 billion. But some analysts looked in depth at their derivative books and couldn’t figure out how the company was earning all that money. There was a gap between what was reported and what they could confirm. We know how this story ends: Enron filed for bankruptcy in December 2001. The executives used a willful, systematic, and intricately planned accounting fraud to inflate their earnings.

Enron stock. Source: Bloomberg

Investors could have improved their relative performance by avoiding Enron. That was tough to do: the company was a media-darling, considered a high-flying harbinger of the new economy. It had tremendous price momentum. But it was hard to see how they could turn 2% growth in utility revenues into consistent double-digit earnings growth for themselves.

By looking under the hood — understanding the business, reading the financials — investors can sometimes avoid the big flops. And just like when kids take the SATs, if you can improve your odds, in a low-return world, that just might be enough.

Douglas R. Tengdin, CFA

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