5 Disadvantages of Mechanical Investing
- One-time Charges and/or Gains Can Skew Statistics.
One-time, or "special", charges and gains are a common fact of life in the investing world. For example, a company could sell a piece of real estate is not longer needs for a one-time gain, or take a one time charge for reducing the value of goodwill on the balance sheet. The problem with these is that they can greatly skew valuation statistics, adversely affecting a statistical screen. That one-time gain from a real estate sale can artificially inflate earnings, making the P/E ratio look much cheaper than it actually is based on on-going operations. Without taking the time to research the company's financial statements, this would go unnoticed by a mechanical investor. Good mechanical screens try to account for this, but it's not always possible for a computer algorithm to catch these discrepancies. Which brings us to the next point...
- Accounting Methods Differ Between Firms.
Generally Accepted Accounting Principles, or GAAP, are used by all public companies, but GAAP allows for a lot of freedom in classifying assets and earnings. What this means is that, when looking at a statistical screen, we may not always be comparing apples to apples. Take a simple, and relatively common, mechanical screening criteria - price to book ratio. How a company calculates book value can differ greatly. Take, for example, Harley-Davidson (HOG). The main competitive advantage for this company is their brand name - but this asset is not recorded anywhere on the balance sheet, so HOG's price-to-book looks higher than a company that does record branding as an intangible asset (like, say, Coca-Cola (KO)). Peter Lynch, in his book One Up On Wall Street, talks about how Pebble Beach's gravel pit real estate asset was worth several times what it was recorded for in the balance sheet! Without due diligence, these kinds of things are impossible to know by using just a mechanical investing approach.
- Mechanical Strategies are Often Very Volatile, Making Them Difficult to Stick To.
Joel Greenblatt, in The Little Book that Beats the Market, spends a lot of time talking about this point. All too often, an investor decides to base his strategy on a mechanical technique, just to find his portfolio trailing the market after a year (or less). These results lead to the emotional conclusion "this doesn't work!", despite years of data showing that it does. The investor drops the strategy, which then goes on to crush the market for several years. The Magic Formula, and many other mechanical strategies, can be volatile. There will be periods where they trail overall market returns. The mechanical investor must have a strong will and conviction that the strategy will outperform the market over the long term.
- You Know Little About the Companies You Entrust Your Money To.
Probably an offshoot of the last point. For many investors, blindly buying stock in a company without knowing anything about it seems risky and foolish. There is not much else to say on this one. It is a major hurdle for many people, and for some people it will not bother them at all.
- Driving Using the Rear-View Mirror.
Clearly the biggest problem with mechanical investing is the "driving using the rear-view mirror" aspect. What this means is that you are investing based on past results, instead of taking into consideration future prospects. After all, it is future results that will determine the success or failure of your investment, not past performance. Sure, Crocs (CROX) were all the rage the past few years, earning a ton of money, but is it likely this fad will earn those same dollars going forward? Maybe that low P/E ratio is warranted. Many large banks looked downright cheap on a price-to-book basis at the beginning of the year. However, as huge write-offs were announced, the "B" part of that ratio dropped in a hurry, and now those "cheap" prices don't look so attractive. Doing some fundamental research could have at least raised red flags on these potential future problems, something a mechanical screen would not have found.
Mechanical investing has a lot of great aspects, but some risks as well. The goal of MagicDiligence is to use a very successful mechanical screen, Joel Greenblatt's Magic Formula Investing screen, while eliminating the disadvantages of the strategy. Through MD's stock research reports, you can eliminate the risks of not knowing about your investments, not accounting for future prospects, and missing accounting anomalies. Also, since the MagicDiligence Top Buy list only contains companies with strong and durable competitive advantages, we aim to reduce the overall volatility of the strategy, making it easier to stick with for long periods of time. Take a look at our Top Buy list for FREE and see how it can improve your Magic Formula Investing experience.
Disclosure: Steve owns no stocks referenced here.
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