Improving Investor Returns: 3 Benefits of Watchlists

When investing your own cash, its important to find an edge that helps to improve returns and beat the market over time. Often times, investors look for specific insights, techniques and information (or even “tips”) that can give this edge. Warren Buffett cautions investors against such tips – “With enough insider information and a million dollars, you can go broke within a year.” But are there legitimate ways an investor can use information that’s publicly available, regardless of investment style, and improve their own psychological biases that encumber so many investors? Yes – by using a watchlist.

In its simplest form, a watchlist is a list of stocks, which as the name implies, you watch. Nothing genius about that. But what is useful is that the watchlist should be comprised of stocks that meet some of your investment criteria, though probably not the price criteria at which you’d be willing to buy. While this post focuses on using a watchlist for listed stocks, it could just as easily be adopted to work across many investment styles, and for investment in private companies by VCs and angel investors.

In my own value focused investing approach, using a watchlist means identifying stocks which have positive and healthy earnings per share (EPS) growth over 5 or more years (over 10 years is really good), a high return on equity (ROE), a strong balance sheet and in a space I can understand. For the time being, that’s largely why I focus on medtech stocks, since insights from working inside the industry means you can leverage your knowledge. Many such stocks can meet this criteria at any one time (typically my watchlist is over 50 stocks), but very few are at a price I’d be willing to pay. So, in the last 6 months since starting to use watchlists, what 3 benefits have I found and do they help to improve returns?

Discipline. Before using watchlists, I would run monthly screens based on the criteria above, then sift through manually to see which stocks met my criteria or investing rules. From an initial list of typically 150-200 stocks, maybe 10-15 would pass through the manual sift. It would feel like I’d uncovered some hidden gold, and eager to press the trigger, I would go ahead and buy. But in this rash of activity, and in my eagerness to not miss out on any big “scores”, it usually meant not properly following my own investment rules. Big mistake. And expensive. It also meant I didn’t focus on any particular sector, again not wanting to miss out. This mode of hyperactivity also plays on the sell-side, detrimentally. I would sell out of situations on short-term negative news, ignoring my own investment rules for selling a stock. Again expensive – missing on any recovery within the longer-term reason for my buy.

Now, since using a watchlist, instead of running a new screen every month across all sectors, I spend time building up my understanding of stocks within one sector – medtech (and a little more broadly, healthcare). I feel as though I can afford to do this since using a watchlist means I can build up a roster of stocks I like over a period of time. These have most of the investment criteria noted above, but are usually more expensive than I’m willing to pay. I can only buy anything on a watchlist once it falls below my pre-determined buy-price target. A bit like going to an auction – know before you get in the room what’s the most your willing to pay for anything, and don’t go beyond this price no matter what. Or else mania gets inflated (along with your ego), and your wallet gets deflated. Rapidly.

Also, as I become less trigger happy, a watchlist enables me to think more closely about each situation, and base any buys on more accumulated knowledge about a smaller and niche focus of stocks. This leads on to the 2nd benefit of using a watchlist…

Patience. I’m no scholar of poetry, not at all. But years ago as a student, I was inspired by Rudyard Kipling’s poem, “IF”. In the opening lines, he writes “If you can keep your head when all about you, Are losing theirs and blaming it on you…” As far as I know, Kipling was no investor, but his words are priceless advice. A watchlist does this – it enables you to have patience, “to keep your head when all about you are losing theirs”. This means you can assess situations quietly (new and existing; buys and sells), away from the noise and the constant stream of internet enabled market chatter.

You get to know your stocks over time, how they respond to market developments, what issues really impact valuation, and where the underlying businesses are heading. Then you just have to wait. Wait until the market presents a buying opportunity. When such a stock situation arises, reassessing it in the light of new information is usually fairly quick – its framed against your existing knowledge of that situation and developments within the sector and competitors.

I also find when such a buying opportunity presents itself, a small dose of simple technical analysis helps me too. Generally this is to try to avoid an imminent catastrophe in the situation which the market may know ahead of time. But regardless of what you think of technical analysis, the important point is the patience afforded by a watchlist gives me the time to do final sanity checks before pulling the buy or sell trigger.

The patience factor also helps me sleep better. There are very few situations where you don’t have at least a little time to think about a new situation or development within a watchlist stock. Signs are usually developed over days or weeks (very rarely, though occasionally over hours). The psychological benefit is the same type as being in the auction room again. If you know ahead of time how you will respond to any range of developments within your watchlist stocks, then responding is much easier when it’s based on considered rational thought, rather than in the grip of a market driven reaction (or worse, hysteria). Having the discipline and patience leads to the third benefit…

Returns. This is where using a watchlist gets really interesting. Too often, when considering a situation, investors thinking is overweight potential return, and underweight risk to capital. I’ve been as guilty of this as any. Particularly when I first started investing in the go-go days of the dot-com boom. On some wonderfully intoxicating days, my portfolio would be up thousands of pounds in a single day. I thought I, young punk of know-nothing investing, had discovered the secret to investing returns: buy the stocks that had steam, a sexy story and ride them out to the sunset, selling onto the next greater fool. To my dismay (and as I now recognize, for my investing education), I was the greater fool. My very occasional fabulous single day returns were dwarfed by annual losses. But I survived. And I got more curious. How to get returns?

Now, several years on, a watchlist is perhaps one of the most valuable parts of my investment toolkit. My returns have improved by: avoiding over-trading; focusing on my chosen niche of medtech and building up a working knowledge of the industry, businesses and stocks; thinking about how I would react to situations ahead of time; and sticking much more closely to my buy and sell rules for stocks. A watchlist creates the environment for me to more effectively be able to do all of these things.

And perhaps most importantly, I can wait until Benjamin Graham’s “Mr Market” (described in his book, the Intelligent Investor) acts irrationally, and take advantage of such timing and pricing opportunities.

So, how has using a watchlist affected my actual returns? Since using one, I’ve only bought 3 stocks. This will be tempting fate, and investment karma being what it is, maybe I shouldn’t disclose. Ahhh, what the heck:

  • Medtronic (NYSE: MDT): Buy Aug 16, 2011 @$32.35, trading now $39.94, +23% (S&P 500 comp: +14%)
  • Life Technologies (NASDAQ: LIFE): Buy Oct 17, 2011 @$36.92, trading now $46.92, +24% (S&P 500 comp: +13%)
  • St Jude Medical Buy (NYSE: STJ): Buy Dec 12, 2011 @$34.91, trading now $43.08, +23% (S&P 500 comp: +10%)

I’m not claiming these three picks prove anything (sample too small, timeframe too short), nor would I expect every stock-pick using a watchlist to work out quite so well. Also, I’m sure now that I’ve shown you returns and how I’ve done with use of a watchlist, by this time next month my portfolio will be in meltdown (there’s another of my psychological biases kicking in again). But at least my investment capital is more likely to live to tell the tale, and I can work within a systematized approach which reduces my less than rational meddling.

And finally, perhaps the most valuable part of using a watchlist is that it brings me closer to Warren Buffett’s two rules of investing: Rule #1 – Don’t lose any money. Rule #2 – Don’t forget Rule #1.

This post is by Raman Minhas. He is a medtech enthusiast, CEO of ATPBio, and works with entrepreneurial companies, providing partnering, licensing and financing support. He is also an investor in medtech stocks, using a value based approach.

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4 thoughts on “Improving Investor Returns: 3 Benefits of Watchlists

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