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Two farmers looking out across the parched High Country

Bloomsbury blog How hot were those hot stocks?

Bloomsbury newsletter, 31 December 2013

At the beginning of each year, investment brokers from the major firms provide their picks for the year. We thought it would be interesting to look at the picks compiled by and National Business Review to see how they turned out. Looking at the year 1 January – 31 December 2013, we found the following:

  • The average return of all broker picks was 16%
  • The average of all shares not picked by brokers (excluding property trusts) was 23%
  • The market return (NZX 50 Portfolio Index) was approximately 17%
  • No one picked Xero, the number one performer (up 325%)
  • The most common picks were Diligent, the third worst performer at -30%, and PGG Wrightson, that returned 0.4% - well under the market average
  • One beleaguered broker picked both Diligent and PGG Wrightson, along with Chorus, which had a return of -45%. The average return of this broker's picks was -15.7%...
  • These facts don't take into account the cost of trading, which may be as much as 1% for each trade

Source: Morningstar Total Returns

What the points above do show is that share picking is extremely hard, and no guarantee of improved performance.

When recommending Diligent, one of the market's worst performers, one broker said Diligent was "at the intersection of two of the most important megatrends in computing, namely 'software as a service' and the iPad. In 2013 we believe Diligent will demonstrate its ability to generate substantial free cashflow while maintaining high growth rates at the top line."

That sounds smart, rational and clear. It sounds like information you should take action on. In fact, there is not a single reason provided for any of the picks that sounds wrong on the surface, or didn't make perfect sense when spoken over a year ago.

But here's the problem – it's invariably information both sides of the transaction (buyers and sellers) already know. Why would sellers, who already own Diligent, not know that Diligent's 'software as a service' business model is positioned to leverage off technology such as the iPad? If both parties know that information, why should only one side expect to profit from it?

Looking at it another way, if both the buyer and seller of a house know the roof is leaky, the price of the house will reflect that. It's very simple really – information known to both sides of a trade will be incorporated into the price.

What subsequently moves prices is information that wasn't known at the time of the transaction. For Diligent, one issue that surfaced in 2013 was that it needed to restate fiscal results from 2010 – 2012, in order to adjust revenue that was recognised earlier than allowed under international accounting standards. This creates uncertainty for investors and the share price reflects this. The market, however, was unaware of this in December 2012.

Dilbert cartoon

Eugene Fama won the Nobel Prize in Economics in 2013 for his empirical analysis of asset prices. Part of this work demonstrated that, in efficient markets, it is only new information that moves prices.

There's one thing that's always true about new information: it's new! This means you can't know it in advance.

When you accept this fact, you realise that a sensible strategy is to give up trying to predict the news, and instead, focus on diversifying broadly. This may not give you the extreme highs, but it should also ensure you avoid the extreme lows.

What do we mean by this? Well, the data tells the story. The best of our surveyed brokers earned an average of 37%. The worst earned -15%. The market earned 17%. Earning 20% above the market in any one year is very nice indeed, but underperforming the market by 32% can be devastating.

While the diversification story may not sound as sexy as "Hot Stocks for 2013", and it may not sell as many newspapers, we think greater certainty about reaching your financial goals is pretty hot...