Here's Why Fundamental Investing is Flawed

Just came across a post about why Lucent might be a good buy over at The Stock Market Blog.

He talks about the attractiveness of buying the stock because its fantastic cash flow and its monstrous 13% dividend.

Yes, you read that right. Lucent, the voice, data, and video communication services company, pays a very high yield. This particular stock is not the Lucent common stock that used to trade on the NYSE under the symbol LU, nor is it the Alcatel-Lucent (ALU) common stock which is the result of the merger between French communications company Alcatel with Lucent. Of course, I'm talking about Lucent's preferred stock, with the official name of Lucent Technologies Capital Trust I (LUTHP.PK). This is a 7.75% Cumulative Convertible Trust Preferred Security which was first issued in 2002. The stock pays $19.375 per quarter, giving it a current yield of 10.2%.

If you think that Alcatel-Lucent is a survivor, and you like high income, it may be worth taking a closer look at this investment. It is convertible into the common shares but it is far away from conversion, as the conversion share price is 24.80. Could the common go that high before 3/15/2017, the trust's maturity date? Stranger things have happened, but even if it doesn't, as long as the company stays in business, you will also make about $240 per share in capital appreciation as the stock recently traded at $760 per share. This boosts the yield even higher, giving it a yield to maturity in excess of 12.9%.

Will Alcatel-Lucent survive? The stock is trading at its cash per share, which doesn't mean much, as the company carries a huge amount of debt at $6.1 billion. On the plus side, it has the same amount of cash. Although the company has been reporting negative earnings, the operating cash flow has been running at $380 million and levered free cash flow is at $1.1 billion.

 The problem is that, like most fundamental investors, there's no mention of how many shares we should buy and at what point we should cut and run if the investment is not going in our favor. Now, I don't expect him to tell us these things, but he seems like the type of investor who doesn't worry about limiting his risk and cutting his losers short. He's in for the long haul on Lucent. And that strategy may be working well for him. He might have a decent buy and hold strategy in his mind with rules for getting in and out that he doesn't reveal to us. But for the most part, most buy and hold investing strategies are just seat-of-the-pants appeals to gut feeling. You just have a good feeling for something and go for it. The problem is that when you don't look where you leap, you might find that you don't like where you land a lot of the time.

Proof that Analysts Don't Know Squat

If you've read my book Boot Your Broker: Investing Secrets that Wall Street Doesn't Want You to Know yet, you know that I criticize "fundamental" buy-and-hold analysts a lot. They research a company, look into the tiniest intricacies of its operations, analyze the current growth of the business, and predict how the company's earnings will grow into the future. There are two serious problems with this strategy:

1. You can't predict the future. No matter how likely your prediction might be, you cannot rely on the future to play out that way. (You have to bet on probabilities and be prepared if that prediction doesn't go your way - something that fundamental analysts do not plan for).
2. Even if you could predict the future of a company's earnings 100% of the time, you wouldn't ever know for sure how that would affect the stock price. Sure, if you absolutely knew ahead of time if a company was going to shatter expectations with a hugely profitable quarter, the stock would most likely go up. But barring a spectacular beat or miss of earnings expectations, you cannot predict how the market will digest the news and how the price of the stock will be affected. Even if the earnings are "good" and you know this ahead of time, a stock trending to the downside will likely continue even if there is a short few-day spike in the stock price. If the earnings are "bad," a stock trending to the upside will likely continue to climb higher. The market is very unpredictable. If you count on one single outcome to occur and do not bet wisely on high probability moves, you're just begging to be torn apart by the stock market.

So those are the two biggest problems with using analysts' strategies to buy stocks. Want a little proof? Well, look no further than McKinsey Quarterly. In this newsletter, McKinsey shows that analysts don't even correctly predict the earnings results of companies.



Over 25 years now, analysts have consistently been too optimistic on the earnings growth for companies in the S&P 500. Despite their enormously high salaries and fat cat bonuses, they still can't accurately foretell the future! We pay them to be clairvoyant, but really, they're just guessing just like the rest of us.

Now, I know that these guys can't predict the future. I'm just giving them a hard time. But they are paid as if they can predict the future. In fact, it's their job to accurately predict the future. They have all the monetary incentive in the world to put up the right numbers. But they just can't. It's not possible.

And that's exactly why it's silly to try to rely on earnings predictions to determine what stocks to buy. You can't know how the future earnings will be digested by the stock market, and you can't even know what those future earnings will be. So let's just get right down to betting on trends in the stock price and riding those out to profits.