Circle of Competence

Sorry for the flurry of posts today. I guess some days I’ll hit you guys with a ton of stuff, and most days there will be nothing. However, I just read a tremendous going-away column from Herb Greenberg of Marketwatch. It contains some terrific advice, and I think my readers should take advantage.

Herb has written articles on Marketwatch about hundreds of different companies. The articles he penned were well-researched, original, and often humorous. His recent battles with the CEO of Overstock, Patrick Byrne (who is certifiably nuts) come to mind.

Herb has decided to leave MarketWatch to open a stock research firm, and thus his last column appeared today, which you can read it in its entirety here.

Here are the 5 “Lessons” he imparts at the close of the column, the summation of his decades-gained wisdom.

Lesson No. 1: The numbers don’t lie. They can be stir-fried, oven-fried or convection-baked, but in the end they always hold the keys to the kingdom. That is why some short sellers and forensic analysts don’t like to talk to companies. They want to avoid the spin or the face-to-face meeting that can create a psychological connection that may skew what otherwise would be black-and-white analysis. Don’t ever underestimate the power and influence of the human factor.

Lesson No. 2: Quality, not quantity. Ignore the “beat the Street” headlines on earnings. It is what goes into the earnings that counts. As I quoted investment legend Thornton Oglove as saying here the past week, the real story is often on the balance sheet. And let’s not forget the cash-flow statement. And this tip: The more complex and convoluted the financial statements get, especially for businesses that aren’t overly complicated, the more reason to worry.

Lesson No. 3: GAAP isn’t the same as a Good Housekeeping seal. Generally Accepted Accounting Principles, according to which all financial statements are supposed to be prepared, include plenty of gray areas that give management enough rope to hang itself. GAAP, after all, is subject to interpretation, and some managers are more conservative than others. Remember, just because the accounting is legal doesn’t mean the end results won’t be lousy.

Lesson No. 4: Don’t confuse stocks and companies. They sometimes go in opposite directions. Stocks sometimes really do lie. Sometimes they are pushed artificially higher by a rotation by investors from one industry group to another, because that one sector happens to be in favor. Sometimes they lie because of short squeezes, which occur when short sellers — who bet stock prices will fall — are for some reason forced to rapidly purchase the shares they sold short. And sometimes they lie because of momentum. Momentum can take stocks to infinity and beyond, but true believers can wind up learning that momentum has a dark side: It is called reverse momentum, and it tends to kick in when you least expect.

Lesson No. 5: Risk isn’t a four-letter word. A good rule of thumb is that before you buy, instead of asking how much you can make, first ask how much you can lose. That is what the smart guys do.

These are things you’d expect to hear from the smartest investors out there, and I have no doubt in my mind that Herb will be immensely successful with his new firm. His message is thus: look hard at the company underlying the gloss.

For every press release, stock update, and talking head commentary, there are thousands of living, breathing companies out there with a unique story. Looking at income statements and P/E ratios don’t tell the whole story, so take your time and learn the businesses you choose to invest in. To be truly successful, one must look past the GAAP numbers, the analyst comments, and the ever-optimistic comments from management, because in those SEC filings there is much more to be found.

Here is the best quote for me, because it could have come right from Ben Graham:

“Don’t confuse stocks and companies. They sometimes go in opposite directions. Stocks sometimes really do lie.”

Good Luck, Herb.