Charles Rotblut is a vice president with the American Association of Individual Investors (AAII). He is the editor of the AAII Journal and helps to manage the Stock Superstars portfolio. Charles is a CFA charter holder and recently authored a book titled Better Good than Lucky: How Savvy Investors Create Fortune with the Risk-Reward Ratio. Charles was kind enough to answer some of my questions.
Thanks so much for your time Charles. I am curious if you can start off with telling us a little bit about your background?
Sure. I started out analyzing privately-held companies and partnerships in the mid-1990s. This involved a lot of onsite visits and careful scrutiny of the financial statements. It was a good way to learn how to be an analyst because there weren’t good comparative valuations and we had to consider what an outside investor would actually be willing to pay. From there, I went to work at INVESTools – a for-profit investment education company, Curian Capital – a money management firm, and Zacks Investment Research – a research firm.
How did you end up at the AAII and make your way up the corporate ladder?
The former editor of the AAII Journal held the position for 26 years. When she announced her decision to retire, I received a call from an old friend who worked at AAII to come in and apply for the position. Though I was happy working as a market strategist for Zacks, this was a rare opportunity at a great organization.
What got you interested into value investing?
Soon after the Internet bubble of the late 1990’s popped, I read Security Analysis by Benjamin Graham and David Dodd; all 700+ pages of it. The book really stood out, primarily because the lessons learned from the 1929 crash were very relevant as the new millennium started.
Though the Chartered Financial Analyst program and my work analyzing private companies emphasized the importance of valuation, it is important to remember that value investing was very much out of favor during the late 1990s. This turned out to be a short-lived event, as it always is. High expectations always come with a very large potential for disappointment. This is why it is so important to manage risk when investing.
Who came up with the AAII survey and can you tell us about the methodology used?
The AAII Sentiment Survey was started in 1987. The survey question has not change since inception and asks whether stocks will be up (bullish), flat (neutral) or down (bearish) over the next six months. AAII members take the survey by visiting our website.
Over its history, extremely high bullish and bearish readings have been correlated with market reversals. For example, on March 5, 2009, bearish sentiment hit 70.3%, right as the bear market was bottoming. Though the results are interesting, investors should look at a variety of indicators before making a forecast about market direction.
Do you have any information on the average of weekly respondents?
We do not conduct a random sampling of our members, the way Gallup poll does with their polls. What we have observed over time is that increases or decreases in the number of respondents do not significantly impact the results.
Also do you have demographic info on respondents, are they mostly retired?
Investors who are AAII members are typically affluent and college educated. The median age is 65, which seems to surprise people when I mention it. Yet, this is very typical of the subscriber base for many investment websites and newsletters.
There was a Wall street Journal article last month which discussed the AAII survey and quoted you several times. The article seemed to paint a neutral picture regarding how the AAII survey is conducted. Do you have any follow up statements you would like to mention?
The reporter interviewed me when he wrote the story. I thought it was a fair and balanced story. Our survey has been correlated with market reversals, but, to reiterate, investors should look at other indicators before making a market forecast.
Does long term historic data indicate when investors are bullish now being an example market returns are usually poor and vice-versa?
We’re presently seeing the second-longest streak of above-average bullish readings since the first half of 2004. Bullish sentiment is also high compared to its historical averages. Based on current readings, a case could be made for market performance to be disappointing over the next six months.
The big caveat is that we saw a 43-week streak of above average bullish sentiment in 2004 and that was followed by another 19-week streak of above average bullish readings. So the question is whether we are seeing what could become another repeat of 2004? Just keep in mind that history never perfectly repeats.
Why do you think investors are always so wrong, do you think investors get caught up with the herd mentality?
It’s human nature to want to be a part of something, particularly something that is going well. Add in greed and you have the right mix to bid up assets. Manias have always occurred, whether it is shares of Facebook now, stocks in the 1920s, railroads in the 19th century or tulips in the 17th century. More manias will occur again; it’s not a question of if, it’s a question of when.
What inspired you to write your new book Better Good than Lucky?
There is a gap between the ideas expressed in much of the great investment literature that has been written over the years and many individual’s personal strategies. I saw an opportunity to bridge this gap by writing a book that explains those key concepts in easy-to-understand language.
If you had to sum up your book in a few paragraphs what would be your main points?
The key to any successful investment is to maximize the potential for reward and minimize the potential for downside risk. In terms of stocks, this means seeking out companies with good business models, strong financials and attractive valuations. It also means buying companies that add to your portfolio’s diversification, not subtracting from it.
It is also important to keep a journal of all investing decisions. Write down both the reasons you are attracted to a stock and what could cause you to sell it, before you buy a stock. The reason is that you have no emotional attachment to the stock before you buy it.
In sum, investors will really benefit if they take the time to truly assess a company’s potential rewards, its risks and a have a plan for selling.
In your book you discuss how to evaluate stocks, how much emphasis do you put on the qualitative versus the quantitative?
I give readers a 10-point scoring system for evaluating stocks in the last chapter. Eight of the criteria are quantitative, while just two are qualitative – business model and diversification. As important as it is to have an attractive valuation and good financials, the numbers cannot tell you everything. For example, nothing in Apple’s numbers tells you that Steve Jobs just took medical leave. I think it is also useful to look at the chart, if for no other reason, than to be sure nothing was missed in your analysis (such as a big news event) and to be sure you are comfortable with the stock’s historic volatility.
You write in your book about the importance of diversification, many investors would rather put more of their money in their best ideas and prefer a more concentrated portfolio?
Harry Markowitz showed that diversification can both enhance returns and lower risk. Concentrating your portfolio on what are perceived as best ideas means assuming you have the ability to correctly forecast the future.
You should go after potentially profitable investment ideas. But, you should also make allowances for the possibility that you could be wrong. Diversification cushions the blow of mistakes. More importantly, since we don’t know what the best performing asset class five years from now will be, diversification ensures that part of your portfolio will be exposed to the right asset class at the right time.
In your book you discuss four primary concepts; Diversification, Strong business model, Good financials and Attractive valuation. Would you mind elaborating on each of these four points?
These are the four cornerstones of a profitable investment strategy.
Diversification reduces the chances of bad news from one industry or sector adversely impacting your entire portfolio. It also ensures that part of your portfolio will be allocated to the right asset class at the right time. The future is unpredictable and diversification provides the best defense against uncertainty.
A business model is what a company does to make money. At the most basic level, a company should produce products that customers want at a price that is profitable. A successful company also enjoys a competitive advantage. Businesses fail when they cannot fend off competition, are unable to maintain customer loyalty or are unable to adapt to changing conditions.
Good financials mean a company is profitable, generates cash flow and has enough cash to fund daily operation. I always look at the cash flow statement, because if a company cannot generate positive cash flow from its operating activities, it will be forced to sell shares, raise debt or curtail operations.
Valuation is the most important determinant of whether a stock’s return will be greater or less than those of the markets over the long-term. Numerous studies have shown an inverse relationship between a stock’s valuation and its performance. This is not only about buying low and selling high, but also the simple fact that higher valuations reflect higher expectations. The more people expect a company to do well the greater the risk of a disappointment, and thereby, a plunging stock price.
What type of reader would benefit the most from your book i.e. beginner, advanced?
I wrote the book to appeal to all levels of investors. A beginning investor will learn how to thoroughly manage a portfolio, analyze financial statements and a value a stock. An advanced investor will be challenged to think about how they’ve traditionally invested and whether their strategies need revising.
You discuss Ben Graham and Philip Fisher in your book. The readers here are big fans of them can you tell us a bit more what you write about them?
I pull concepts from both of them. I’m a value investor and I think it is important to pay attention valuation. Readers will see that I emphasize valuation in the book, a theme that flows from the influence Benjamin Graham’s writings. I don’t think low valuation is enough, however, and this is where I find myself agreeing Philip Fisher. A company has to produce products that fulfill a need and have the ability to defend its niche. Fisher emphasized the importance of strong management teams and a process for replicating success. I think finding companies with these traits helps to separate those companies that are true bargains from those that are merely cheaply valued.
Finally, do you plan on writing any future books?
I have been approached about writing a second book, but have yet to put pen to paper, so to speak.
Thank you for your time!
To purchase Charles Rotblut’s book on Amazon.com click on the following link-Better Good than Lucky: How Savvy Investors Create Fortune with the Risk-Reward Ratio