My take on Data-Driven Investing...

I didn’t take business classes in college; I don’t own stock (or have the liquid assets to purchase any); and, although investing always seemed to be an attractive option to me, I was never exposed to the inner workings of any financial institutions. My first exposure to stock trading was when I met Bill Matson, my Harvard Business School alum boss.

Two and a half years ago, I edited Data-Driven Investing, the research-based stock market investors’ guide which was the book written by Bill and co-author Mitch Hardy. The book, intended for individual investors, describes, through research, (with their figures well-documented) numerous tips on what to look for when investing money. The two men also collaborate on a money-management firm based in Newburyport, Massachusetts.

Smart businesspeople have given favorable reviews to Data-Driven Investing. The book is full of good stuff such as: how to pick stocks, when to buy more shares and when to sell ‘em, and how to use current news stories to help you make your decisions. One thing that I definitely think is a strength of the book, from my untrained point of view, is the proof that Bill and Mitch provide to the reader. They invested their own money from July 2000 to March 2004, and to prove the success of their research, Bill published his brokerage statements in the book. That way, you can see what the outcome of the “Data-Driven” method is.

Most people have probably heard of Warren Buffett, at least in passing. (No, he’s not Jimmy Buffett’s brother. People always say that!) In the business world, this guy is known as the “Sage of Omaha”. He’s the second richest man in the world, after Bill Gates, and the reason he’s a multibillionaire: he was a pioneer of investing. (This guy bought his first stock at age eleven!)

The reason I bring up Warren Buffett is that this guy is a stock market genius, an innovator. And, acclaimed as our friend Warren is, Bill’s returns in the early 2000s surpassed Buffett’s best five-year period of success, in the late seventies. Bill beat the S & P 500 index by 930%, compared to Buffett’s 921%!  And, to beat that, the S & P 500 (the most well-known stock market index) was gaining 90% during Buffett’s greatest five-year run, whereas it was returning only 5% during Bill’s, in a time when the stock market was not doing well at all. So…this stuff works.

I’ll outline some points about Data-Driven Investing; the ones I can understand!

First, this style of investing deals with a large number of (usually) domestic, small-cap value stocks. Small caps are companies that have a market value of less than a billion dollars. Value stocks are stocks that trade at a low price relative to its earnings, dividends, and sales. So, you’re looking at investing in a number of small, mostly U.S.-based companies in a variety of industries. By investing this way, no one stock is going to make you or break you.

Of course, you have to have an idea of how to predict which stocks are going to do well, and how to trade accordingly. One of the most important things to check is whether there has been any sort of news stories about the companies you own stock in. You can get this information from financial websites such as Yahoo Finance, AOL Finance, or brokerage sites such as Fidelity and Merrill Lynch.

Here’s a current example of Bill’s logic:

Bill is expecting a tough market between now and October; risky stocks (small companies and growth stocks) are likely to be down and large company value stocks are likely to break even. November and December are likely to be good months for all types of stocks, especially the risky ones. He bases this on three things:

1. The Fed is up, so rates on loans are higher. This means that it’s a good time to own large company value stocks…and a good time to short risky stocks on bad news. What does that all mean? Well…

The Federal Reserve System (or Fed) is the central banking system of the United States. All national banks are required to join the system, and other banks may join as well. In 1914, Congress created the Fed (and also Federal Reserve notes, our paper money system).

One of the responsibilities of the Fed is to adjust the Federal Funds Rate. I sure didn’t ever know what the Federal Funds Rate was, but since I figured it out, I’ll share. it’s the interest rate at which financial institutions lend balances, or federal funds, to other depository institutions. “Financial institutions” are places which act as agents to provide financial services to their customers (i.e. banks, stock brokerages, and credit unions). These financial institutions work by moving funds from investors who have “excess funds” to companies that need money. 

Historically, the stock market performs better in times when interest rates are dropping, rather than rising. If loans come with lower interest rates, it’s going to be easier for consumers and businesses to buy and build, which stimulates economic activity. The less money you’re going to owe in interest, the better the loan is from your side of the table, and you feel much happier about your brand-new BMW X5 personal “company car”. Higher interest rates slow the economy by increasing the cost (in interest) of borrowed money. The Federal Reserve will adjust the Federal Funds Rate by .25% or .50% at a time according to what’s going on in society; for example, to fight recession, the Federal Reserve is going to incrementally lower its interest rates, until things start looking up in the financial world.

2. The presidential election cycle.

2006 is the second year in the election cycle. The market tends to perform much better during the 3rd and 4th year of the presidential election cycle, (the “late years”) rather than the 1st and 2nd (the “early years”). The reason for the better market returns in the late years is that government spending is consistently higher in the last two years of a presidency (a proven fact). Presidents have a long history of losing their bids for re-election when the market is down during their campaigns. President Bush wanted a strong market for 2004’s voting…so in 2003 he pushed for tax cuts that would have a positive effect on stock prices.

3. Summertime and shorting stocks.

Shorting stocks is another avenue that can be researched. If  you’ve been paying attention to “good news” and “bad news” in regards to the companies that you own stock in, you could make an educated guess as to what stocks are going to go down in value in the near future. Those, surprisingly, are the ones you want. In that case, you could borrow 20 shares of Company X for $50 each from a shareholder, with the promise that you will return the 20 shares of Company X stock at some point in the future. You sell the shares for the same price they were when you borrowed them, and then you have your $1000. If you were right in your assumption that Company X’s stock was going to go down, and the next month it’s dropped to, say, $25 per share, then you purchase 20 more shares of Company X stock at half of what you originally paid for it – and return it to the person you originally borrowed from. Profit = $500.

Summertime, or May – October, are historically weak months for the market. Investors are off in exotic islands, taking time off on their yachts, which in turn will cause securities salespeople to take time off. Due to the time of year, money is more likely to be spent on boats, travel, second homes, etc. and less likely to be put into stocks. Stocks in summertime are more likely to be sold to fund these purchases. Stock prices, ultimately, are set by supply and demand – so if the supply goes up (due to selling), and the demand goes down, the prices are also going to go down.

And so maybe, if you’ve read this far, you can think about some investing! If I ever find myself with some sort of surplus of funds, I’ll stick some money into the stock market. And I’ll let you know how that goes.