There is intelligence and then there is wisdom. We are all born with intelligence, but we pick up wisdom along the way. I'm no more intelligent than when I got into this business 20 years ago, but hopefully, much wiser. The key evolution: I now develop far fewer mistaken assumptions about the stocks and industries I analyze. With this in mind, here are five things I learned in 2011 that will (presumably) make me wiser in the years to come...
1. Industry selection is far more important than stock selection
I spent too much time this year focusing on the best play in a particular industry. For example, I suggested Delta (NYSE: DAL) was the best airline stock to own for the coming year.
Yet the whole group really moves in tandem, and it would have been far wiser to suggest the right entry point for the group, and not the stock. Indeed Delta and the AMEX Airline index (XAL) have traded in virtual lockstep since that late July recommendation.
Of course, my expectation that AMR (NYSE: AMR) would run into financial distress highlights the value of assessing company-specific drivers -- especially on the short-side. But most of the time, there's more value in a top-down call on the right industry than the bottom-up call on the right stock.
2. Shun negative cash flow stocks when the economic environment remains uncertain
Throughout 2011, I recommended a few development-stage biotech stocks, including Celsion (Nasdaq: CLSN), Threshold Pharma (Nasdaq: THLD) and BioSante Pharmaceuticals (Nasdaq: BPAX). Each of these companies is in the process of testing novel new therapies and could -- one day -- be home-run picks. But these are the wrong kind of businesses for weak economies. These biotechs need serial capital injections to fund their clinical trials and, because as they waited too long to raise fresh capital, their shares have gotten crushed. The outlook for 2012 is probably no better, so expect few new biotech ideas from me.
3. If some think there is a looming glut in a given industry, then they're probably right
Early in 2011, a small chorus of voices suggested the solar-power industry and the natural-gas producers were engaged in a battle to ramp up output that would wreak havoc. They were right, and as a result, prices for solar panels and natural gas fell and fell some more. In the solar space, a few companies are now flirting with bankruptcy. In the natural-gas industry, few near-term drivers exist to brighten the industry outlook. When the shakeout comes and supply finally falls to the level of demand, these will be appealing industries, but they're surely dead money until then.
Supply and demand will always be the key factor driving profits in any industry, and I let this concept get away from me when looking at company-specific dynamics in these energy subsectors.
4. The next quarter always matters
In years past, investors tended to focus on the year ahead and would buy stocks that would likely post solid results down the road. This is not the case anymore. These days, investors will punish a stock if the current quarter is weak, no matter how good the longer-term view may be.
In September, I took a bullish view of Micron Technology (Nasdaq: MU), noting the stock was very cheap at less than 75% of tangible book value. I noted shares had recently been weak "due to a slowdown in demand for DRAM [or dynamic random access memory], which caused a glut of chips. The good news is pricing is likely to improve later this year."
Later this year?
I failed to acknowledge the reality that Micron still had another bad quarter ahead of it. The chart below shows how that played out. You could have actually bought this stock for less than $5 if you waited for the fourth quarter to roll in. Everyone knew it was coming, but I mistakenly assumed investors would look beyond that event.
5. Valuations matter
This is a lesson I absorbed years ago, but it's worth repeating for those investors who made this same mistake in 2011. If a stock has a really rich valuation, then you shouldn't own it. The risk is far greater than the reward at a time when so many other stocks sport very low valuations. For every Chipotle Mexican Grill (NYSE: CMG), for example, which manages to stay aloft at 60 times trailing earnings, you also may find a Netflix (Nasdaq: NFLX), OpenTable (Nasdaq: OPEN) or Sodastream (Nasdaq: SODA), which ended up falling 77%, 69% and 56%, respectively from their 52-week highs as lofty growth expectations couldn't be met.
I'd much rather own a stock like SodaStream once it's no longer being chased by momentum investors. [You can read my take on whether I think that's happened or not in this article.]
Action to Take--> How will these lessons affect my outlook for 2012? Well, expect a continued focus on inexpensively-valued stocks and an ongoing search for potential short candidates that may be imperiled by a still-weak economy. The short- to mid-term outlook calls for pivoting between buying opportunities when the market slumps badly and profit-taking whenever the market is in the midst of an extended upward move. A similar approach may be the wise route for you next year as well.
Disclosure: Neither D. Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.
This article originally appeared at www.streetauthority.com