22 Mar Professional Stock Picking – How is it Done?

Stock picking is not in fashion. Most people are buying indices because most fund managers aren’t beating the indices and they figure that if a fund manager can’t beat the stock market then how can they!

But when everyone is doing the same thing, it usually pays to do the opposite!

Many of the unloved stocks in the early 2000s, when the world couldn’t get enough of the Nasdaq, or Tech stocks generally (another period where fund managers and individuals were struggling to beat the indices), did quite well during the onslaught now known as the Tech Wreck. A rigid value screen would have turned up Philip Morris shares in January 2000 (among other tobacco, consumer durable, mortgage and real estate shares). During the period between January 2000 and January 2002, Philip Morris shares gained over 150%, not including dividends! The Nasdaq Index lost more than 50% in value during the same period.

Ben Graham, the legendary value investor, taught us that “Price is what you pay, Value is what you get.” No truer words have ever been spoken. Google is a great company, but would you rather pay a P/E of 30 for an earnings growth rate of 21% (Currently) or a P/E of 21 for an earnings growth rate of 28% (2010). Today you pay 30% more for Google than you would have in 2010 (the P/E multiple is 30% higher today) for 25% less growth (today’s earnings growth rate is 28% vs an earnings growth rate of 21% in 2010, a difference of 25%). You get significantly less value today on the purchase of Google shares than you would have in 2010. The more value you get, the more likely you are to generate good returns in the future.

There was a time 4-7 years ago when the large majority of stocks were cheap. The market is certainly not offering as much Value now as it was a few years ago;

• In 2007, the S&P 500 index traded at a P/E of 16.8. At the low in 2009, the P/E was 9.9. Today the P/E is 18.4.
• The FTSE 100 traded at a P/E of 13.2 in 2007. At the low in 2009, it traded at a P/E of 6.5. Today the P/E is 15.
• The FTSE 100 & S&P 500 are both more expensive today than in 2007!
• The German DAX index traded at a P/E of 14.5 in 2007. At the low in 2009, it traded at a P/E of 8.2. Today it trades at a P/E of 14…. A bit cheaper relative to its US & UK counterparts, but still a P/E nearly as high as it was in 2007.

We are likely not at a point of the cycle where you can expect to generate positive returns in the near future by owning an index. So stock picking is definitely now in play.

It is important to understand the different genres of stock investing and how they relate to your individual expectations. There are 3 main genres: Value, Growth & Income.

Value Investing: The strategy of selecting stocks that trade for less than their intrinsic values. Value investors actively seek stocks of companies that they believe the market has undervalued. They believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond with the company’s long-term fundamentals. The result is an opportunity for value investors to profit by buying when the price is deflated.

Growth Investing: Growth investing is a strategy whereby an investor seeks out stocks with what they deem good growth potential. In most cases, a growth stock is defined as a company whose are expected to grow at an above-average rate compared to its industry or the overall market.

Income Investing: Aims to pick companies that provide a steady stream of income, perhaps one of the most straightforward stock-picking strategies. When investors think of steady income they commonly think of fixed-income securities (Bonds). However, stocks can also provide a steady income by paying a solid dividend.

From there it is really all about focusing on the style that best suits you and then learning about how to apply time-tested strategies that have consistently beaten the market over the long run. The reality is that there are some great resources available online reasonably cheaply (free in some cases), that give you the tools which would have only been available to professionals 20 years ago.

Some concepts are basic but they can go a long way to helping investors to avoid some of the major pitfalls that cause people to underperform. For example, dividend-paying stocks tend to outperform non-dividend paying stocks, but reaching for big dividend yields is not a good idea in the long run. The green line in the graph below shows the historical performance of all stocks in the S&P 500 index that pay a dividend of 6% or more & the red line is the S&P 500; Ben Graham’s was a big advocate of buying cheap stocks. Of course, you can’t go out and buy the cheapest 10% of stocks in the entire universe on an equal weighted basis, but have a look at a backtest of the cheapest 10% of a 13,000-stock universe based on Graham’s Book Value metric. Cheap stocks tend to do better & the cheapest stocks tend to do the best; Sentiment Measures are also critical. John D. Rockefeller always said that when the shoeshine boys are giving you stock tips, it’s time to sell everything with both hands. Rothschild always said that when there is blood in the street, one should buy assets. Today there are tools online that allow investors to track market sentiment in simple ways. Sentiment measures are very helpful in terms of determining whether it is safe to hold stocks or not. Don’t get me wrong, we believe in long-term investing, but not everyone has the luxury of launching a portfolio in 2010. If you are putting new money to work now, you want to know who is buying and who is selling. If classic underperformers (known as the dumb money on Wall Street) are aggressively optimistic about stock prices at the same time as classic outperformers (Known as the Smart Money) are aggressively pessimistic, well, you want to be with the smart money. At BAGGOT Investment Partners we educate our clients on the importance of harnessing Sentiment Measures online, not only to show them how we can outperform the market but also on how we avoid periods where investors are exposed to the significant potential for loss.

• Sentiment Indicators are a wonderful compliment to any investing strategy.
• They can help you to be aware of points in time where there is significant opportunity that most participants do not see.
• They can help you to be aware of points in time where there is a significant level of risk that most participants do not see.
• They can help you to avoid significant losses in a way that fundamental analysis cannot.

Why do the casinos in Las Vegas always win in the long run? Because they only take bets when they have a statistical advantage. So when you are stock picking make sure to do your research, pick a strategy and take into consideration Sentiment Measures.

BAGGOT Investment Partners – Investing Service

At Baggot Investment Partners, we have an expert team of advisors that help our clients to utilise world-class investment advice and strategies in order to secure better opportunities for their financial future. If you are interested in getting a return on your portfolio or have funds to invest please contact us at BAGGOT Investment Partners and we will be happy to advise you.

About the Author

Peter Brown is an Investment Advisor and owner of BAGGOT Investment Partners. Peter is best known for his media commentary on the financial markets with his clear, no-nonsense style. Peter spent his career running treasury departments in several banks in Ireland.

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