Why Most Investment Systems Simply Won’t Work

By Alexander Green on August 14, 2009

Early in my 16-year career on Wall Street, I made an astonishing discovery: The overwhelming majority of my colleagues - bright, educated, experienced, and articulate - didn’t have the foggiest idea what they were talking about. This only became obvious in retrospect, when I saw how their carefully constructed financial theories and investment forecasts turned to dust rather than generating any significant profits.

(You’d be surprised to learn, for example, how many investment “pros” lose a substantial percentage of their own money in the market each year.) The truth is that there are virtually limitless ways to take a beating in stocks - and only a few methods that work well over time. These methods are generally codified into widely accepted investment principles, something we try to emphasize here.

I was fortunate to realize this early in my career, although it still stings to remember the chunk of change I lost 25 years ago buying my own firm’s “Strong Buy” recommendations. However, things finally began to turn around for me the day I read a book  - now sadly out of print - by Harry Browne called “Why the Best Laid Investment Plans Usually Go Wrong.”

(I loved the title, but Harry, who ran for President twice on the Libertarian ticket, once told me he regretted the choice. “Too negative,” his publisher told him.)

Browne argued that the odds are stacked against the typical investor who is overwhelmed by Wall Street’s technical jargon, market volatility and the business of money management. (Read the investment classic “Where Are the Customers’ Yachts?” for details.)

There are exceptions, of course, but the nation’s brokerage firms are filled with well-dressed, smart-sounding individuals spouting a lot of self-serving nonsense. As Vanguard founder John Bogle once remarked, “It’s amazing what a man doesn’t understand when he’s paid a small fortune not to understand it.”

The overwhelming majority of economic theories, market forecasts, trading strategies, hot tips and sure-fire speculations never pan out. Fortunately, we have the accumulated wisdom of the history’s greatest investors to guide us. I’m talking about people like Warren Buffett, Peter Lynch and John Templeton, men whose audited track records speak for themselves.

Even though these individuals used very different approaches, they agreed that in the end there is only one thing that dictates where a stock will go: earnings. Earnings are the net profits of a business. They are what drive share prices.I challenge you to find a single company that increased its earnings quarter after quarter, year after year, and the stock didn’t tag along.

Conversely, try to identify a single company whose earnings declined quarter after quarter, year after year, and the stock advanced anyway. It just doesn’t happen, even in a rip-roaring bull market. The reason is simple. A share of stock is not a lottery ticket. It’s part ownership of a business.  And profits (earnings) determine what a company is worth.

Although there are always bumps along the way, you’ll find there is a near perfect correlation between a company’s growth in earnings per share and the movement of its stock from year to year. So forget all the mumbo-jumbo about market breadth, trading volume, put-to-call ratios, short interest, mutual fund inflows, advance/decline numbers and other market trivia.

And instead remember: share prices follow earnings. Period.
Stamp that on your forehead - act on it - and you’ll be using the one tried and true investment discipline that has always paid off in the end.

True, the earnings at most companies are poor right now due to the severity of the recession. But there are plenty of companies in food, pharmaceuticals, health care services, medical technology, defense contracting, gold mining and other recession-resistant industries that are still making money hand over fist.