There are several ways to approach stock picking. In this article, I’ll summarize them, what the important issues are, what works, and why you should consider enlisting the help of your friendly neighborhood financial professional who might have a CFA.
The first important thing to realize is that if you are deciding to pick stocks, you are deciding to engage in active management, see my “Active Management Alpha” article for a description. You can be successful, but it requires the right resources and experience. There are a lot of people who sell newsletters or provide informal advice on TV, etc. who would have you believe that you can do-it-yourself. It’s not as simple as it sounds, but those people have no vested interest in your success, just in collecting a fee for selling a newsletter etc. Having seen everything that I have, I am skeptical of newsletters because they are unregulated, unaudited, and the authors can say anything they want with the benefit of hindsight.
As I discussed in “Active Management Alpha,” the drivers of returns are dividends, earnings growth, and valuation changes. As you might imagine, the ways people approach stock picking revolve around these return drivers. They generally can be categorized as income investing to collect dividends or growth investing, which can be either GARP (growth at a reasonable price) investing or maybe growth at any price. I’ll discuss dividend investing and growth investing.
Dividend investing starts out pretty simply, it’s easy to spot stocks that pay dividends and see how big they are. What to do next is determine whether those dividends are sustainable, well-covered by earnings or better yet free cash flow and whether they are growing. No one wants to invest in dividend-paying stocks and then find out that their dividends get cut or disappear. Companies don’t like to do that, but their financial condition could make it impossible to avoid, and since so many people are following the money and looking to collect those dividends, when they get cut, for better or worse, there will be a precipitous decline in the share price, even if it was a prudent thing for the company to do, shareholders will be mad.
So, when you’re considering investing to collect dividends, it helps to know about financial statements and how to read them to know if those dividends are well-covered, sustainable, and predictable. You should have a feeling for whether the business is cyclical or not, how much its earnings could vary based on the economic environment, how predictable it is, how vulnerable it is to competitive threats. Also, how much is it growing? How much can the company afford to raise its dividends year after year? That could be an important component of your return. The valuation that you pay for the stock is pretty important. One thing you will notice is that stock prices can move around a lot. In most years, they move around more than the amount of dividends the stocks pay, so the price you pay, when you get in or out matters, maybe more than the dividends you collect. How do I determine what price to pay, you ask? It’s not simple. You want to buy dividend-paying stocks at high enough yields and low enough prices that they are much more likely to go up in price and not down that much from where you buy them. This depends on having good estimates of their fair value and how undervalued they need to be based on how much volatility there is and how they have traded historically. You can look at historical dividend yields, historical price to earnings (P/E) ratios. It might be better to look at price to free cash flow (operating cash flow minus capital expenditures) as part of the cash flow analysis, because some businesses have earnings, but they are so capital intensive, there is not much excess cash that can be used to pay dividends. There are more advanced methods like discounted cash flow models (DCFs) to better estimate a company’s fair equity value. Sometimes companies are issuing debt or shares in order to pay their dividends, and you need to be aware of that and how well covered by operating income the interest payments on their debt are. There might not be enough cash left over to pay your dividend. Issuing shares in order to pay the dividend doesn’t sound right, you say. Yes, in most cases that would be called a ponzi scheme. People can go to jail for that, but corporations can get away with it because they disclose it in their public SEC (Securities and Exchange Commission) filings and you’re supposed to be reading the fine print in those filings.
Got it? Since that was so easy, we’ll move on to growth investing.
Here, the same principles apply and you’re looking for a predictable growth profile that you can buy for less than it is worth. So, you have to be watching and be nimble if a change occurs that could affect the fate of your company’s growth prospects. A popular approach to growth investing is described in William O’Neil’s How to Make Money in Stocks. It’s a good framework for thinking about growth investing. You really want to do enough research on a company, the industry it operates in, its products, and its competitive advantages so you can get as much clarity as possible on the growth trajectory. This can help prevent you from getting scared if you buy a growth stock and then it goes down in price and you think about selling. In truth, typically I only buy growth stocks that I would be willing to buy more of if they were to go down in price from where I first bought them. An interesting situation that occurs rarely is when a company trades at low enough valuation, generates enough free cash, and/or has an underleveraged balance sheet that enables them to issue debt and repurchase a large amount of the shares outstanding, which could lead to a surprising amount of earnings growth and share price appreciation, even in an industry that is not growing much.
“If they[stocks] don’t go up, don’t buy them.” -Yogi Berra
Easy peasy, no problem.
There are more advanced methods like looking for undervalued assets in spinoffs, mergers, bankruptcies, and restructurings. Those methods haven’t worked as well in the last decade, perhaps due to an increase in passive investing, lower interest rates (not much room for debt pressures to subside), more activism, and competition with people looking in those areas.
Finally, the position sizing and risk management aspect is hard to see and appreciate if you’re inexperienced, but it’s crucial to getting better results over time. Once you’ve found good ideas, it’s important, if you can, to know as precisely as you can how good they are. Aside from avoiding the bad ideas, not appropriately sizing up a good idea can hurt you. An error of underinvestment is similar to an error of omission. Perhaps the most important thing here is continual monitoring and discipline around adding to losing positions. There have been notable examples where funds and investors with great records either succumbed to groupthink or refused to properly re-evaluate and admit a mistake and kept adding to a losing position, destroying their record and business.
“It’s ain’t what you don’t know that gets you into trouble, it’s what you know for sure that just ain’t so.” -Mark Twain
Someone once said that in order to tolerate being fully invested in the stock market, you need to be catatonic or dead because there can be so much volatility, particularly in corrections or bear markets. This is where having the right amount of exposure at different times can be very helpful, whether it helps to make more money or not. There is value in taking steps to prevent depression, gastrointestinal upsets, and panic attacks. As your life savings grow, and the reality of not being able to earn it back were something unfortunate to happen becomes more tangible, having a real, comprehensive plan that addresses your needs, whether they be generating an income or providing for long-growth becomes a priority. You only get one shot at your financial life, so it’s important to do it right the first time — an experienced financial professional can help give you additional insurance that you’ll be on the right track.
*This article is for informational purposes only and should not be considered investment advice.