When knowledge can be dangerous

Last week I said it's better to have a broad familiarity of many stocks and a limited commitment, rather than a deep knowledge of a few names and a major commitment. This is a big statement that may appear counterintuitive, so it's worthy of some discussion.

Many investors spend a lot of time researching individual companies, in the process developing immense knowledge about their products and management. A good example was provided by a reader who recently contacted me, whom we'll call Sue. She was enamored with Universal Display (PANL), an up-and-coming maker of light-emitting diodes, and appears to have concentrated most of her wealth in the name.

Right off the bat, let me say I think Sue may well be correct in her judgment of the stock. PANL looks like an amazing company with a seemingly infinite growth potential. But seeing that it had also quintupled between March 2010 and April 2011, I cautioned her that one hiccup could bring out the sellers and inflict a world of hurt upon her.

I don't know if she reduced her exposure, but on May 10 a wider-than-expected loss drove the shares down 18 percent. (Revenue, however, was strong. Longer term, I will seek to get long this name.)

The moral of the story: Sue made 500 percent in a little more than a year on a stock she knew and loved like a friend. A false sense of security may have prevented her from taking profits and using some of that money to get long other stocks that were better able to rally in the shorter term.

An even more dramatic example was back in mid-2008, when I spoke to a credit analyst covering Lehman Brothers. (Let's call him Bob.) I asked him about the investment bank's ability to service its massive short-term debt, which was bigger than the Swiss economy at the time.

He literally scoffed at my line of questioning and told me I had my numbers wrong. After all, it took me all of five seconds to get them off Yahoo Finance, while he was a CFA with years of experience in the bond market!

Bob and Sue both ignored price action in the stock. Lehman, of course, was in a death spiral because it was completely dependent on short-term financing; PANL has merely slowed down after a blistering rally. Despite their stark differences, both looked at their companies in isolation and ignored what the market was telling them.

Taking it a step further, I believe that their intimate knowledge of these companies actually blinded them to potential dangers. And I suspect that it also prevented them from discovering other winning investments. This is why I say it's better to have a limited familiarity of many stocks than a deeper knowledge of a few.

For example, airlines have been one of the best sectors in the last two weeks as oil prices dropped. You didn't have to know what kind of planes AMR or Delta Airlines fly, let alone the details of their union contracts. All you had to know was that they go up when oil goes down.

Another problem with obsessing over fundamentals is that some stocks sound fantastic but simply don't perform. A good example of this is Acme Packet, which I was trying to trade way back in 2007, three years before it went on a massive run.

The flip side of this is that other companies look quite boring but deliver huge profits. Good example here is coupon printer Valassis Communications, which I recently discussed, and W.R. Berkley, an insurer that rallied more than 1,000 percent between 2000 and 2006--even though no one ever wrote or talked about it.

Stocks are like plants and animals in nature: Different ones thrive or perish according to temperature, rainfall, and countless other factors. Fundamental analysis might help you find a beast of a stock but, without a broader awareness of changes in the climate, it might be on the verge of extinction.

(A version of this article appeared in optionMONSTER's Open Order newsletter of May 11. Chart courtesy of tradeMONSTER.)

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Copyright © 2010 OptionMonster® Holdings, Inc. All Rights Reserved.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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