Stock Selection – Beyond Criteria

Many people investing in stocks have not stopped to think about why or how they buy a particular stock. They rarely think about the underlying framework or method they are using. Does it work? Has it been proven? Who else uses it? Can it meet my objectives? Does it fit me personally or psychologically? The lack of a sound, rational stock picking framework may explain why results are often haphazard and inconsistent. It  may also explain why we often let psychology overtake rational thinking, particularly when markets correct. During these times we often follow the crowd. Today we will explain the main frameworks, and help you look beyond often loose selection criteria, to find one that can best meet your objectives.

It might be worthwhile if you listed why you picked a particular stock recently. What were your selection criteria? How were they derived? Are they consistent? Are they objective, verifiable, rational? Who did you listen to? Did you buy just buy the stock based on a tip? Did you buy on a gut feel? I have been around professional and private investors for over two decades now, and while many have a list of criteria, many of us fail to ask if these criteria are based on a sound overarching framework?

At the onset it is important to draw the distinction between trading and investing. We are here focused on long term investing in stocks, not trading, not speculation, not hedging or shorting. Simply, long term buy and hold for capital grown and/or yield. Too often, I see people using trading criteria or a trading method, when they really have investing objectives. When we invest passively in the stock market, we are wanting to buy and hold to compound growth and yield. That is, compound an increase in the stock price and the dividend yield. When we trade we are looking for short term income returns, usually in the form of simple increases in the stock price. It is worth noting, stock trading, long or short, is much more difficult and requires much more time and commitment.

Four Frameworks

From many years of experience and research we have distilled four key frameworks for stock selection.

  1. Pure Value Investing (PVI)
  2. Trend
  3. Momentum
  4. Hybrids

Pure Value Investing (PVI)

Pure Value Investing is based on the classic securities analysis approach gifted to us by Ben Graham and Warren Buffett. I say ‘gifted’ because in my view, it is the only clearly articulated and proven approach to selecting stocks that is readily available to us. In essence, we select businesses to invest in, if and only if:

  1. Great Business. We invest in great companies with a competitive advantage or moat, these are rare; and
  2. Growth. They are likely to continue to grow over the long term; and
  3. Value. We buy them when the stock price (Mr Market) is less than the Intrinsic Value (IV) of the company, where IV is determined beyond simple ratios, such as Price/ Earnings (PE).

These simple, overarching principles of Pure Value Investing immediately debunk the common distinction between ‘growth’ and ‘value’ stocks. Frankly I have never understood it anyway. ‘Growth’ stocks are commonly stocks bought shortly after the Initial Public Offering (IPO) or small / medium caps  that are likely to grow in their stock price over time. ‘Value’ stocks are usually large cap stocks bought at a cheap price, often not linked to IV. PV investors from the above three principles want both growth and value: great businesses likely to continue to grow, bought cheaply.

I use the term Pure Value Investing because sadly the classic principles of Graham and Buffett have been diluted by the media, commentators or others, who often do not fully understand it. PVI is not simply buying a stock cheaply. The key is to find a great company through a rational quantitative, numbers based approach, and then combine it with a qualitative approach, examining the management, moat, prospects, brand and like aspects of the business. Further, many people fail to calculate value properly. They often use simple Price / Earnings (PE) or Book / Value (BV) ratios, instead of thoroughly calculating free cashflows, projecting them into the future, and then discounting them back to the present- the Discounted Future Cashflow (DFC) valuation approach.

Trend

Trend investors are usually chartists or technical analysts. They will buy when an uptrend is ‘validated’ from the charts, usually on weakness, and hold so long as the trend remains. Trend investing is often confused with trend trading. It was pioneered by Jesse Livermore in the early part of the 20th Century who made and lost great fortunes in the US stock market. He highlights the chief weaknesses of any trading approach to stocks- it is often closely aligned to mere speculation, it plays with our psychology, and does not facilitate the compounding of returns.

The threshold problem of using a trend based method to investing in stocks is how to define consistently and objectively a ‘valid’ trend. Many trend investors get caught out when trends change, or there is a sudden correction- do they hold, sell, or buy more? Most people using a trend method do not examine the fundamentals of the company. It is like driving blind in a car during a storm. We often make rash, poor decisions, seeing it easier to follow the crowd. Following the crowd rarely works in investing.

Momentum

The momentum approach was founded by Richard Driehaus in the 1970s. It is similar to a trend approach, except it does not rely on the charts, but just examines the stock price data. Momentum investors believe if a stock price has risen consistently over a certain threshold, then there is a strong probability this will continue. There are two problems here. First, how do we define and prove the initial threshold? Second, how do we know when the momentum comes to an end or changes significantly enough for us to decide to sell the stock?

Momentum investors suffer from the same problems as trend investors. Where trend investors at least had a map, momentum investors just have numbers. For instance, momentum investors rely too much on historical price data. When did historical data determine the future? The link of course is not be causal, but based on probability. However now the problem then becomes how much back testing has been done to derive a sound probability for effective decision making? Additionally, this can change in a heat beat, for example a major existential threat to the company has just emerged. Momentum, like trend investors completely ignore a company’s fundamentals.

Notice the completely different view Pure Value Investors have of market price. For us it is nearly irrelevant. Ben Graham’s famous analogy, Mr market is only useful to determine when we buy below intrinsic value. After this, it is irrelevant and best ignored. For trend and momentum investors, market price is central. The key consequence is that during times of volatility or correction, PV investors will usually buy more great companies because Mr Market is giving us ‘quotes’, even cheaper than the calculated Intrinsic Value. However, trend and momentum investors are often looking to exit their holdings, even if the company has sound long term fundamentals, and so is likely to bounce back in the long term.

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” – Benjamin Graham.

PV Investors welcome corrections, trend and momentum investors fear them. During these times PV Investors will be more creative, often being contrarian to the crowd. Commonly, momentum or trend investors will follow the crowd and exit in whole or in part their positions. PV Investing can thus help us better manage our psychology.

Hybrids

There are many hybrid approaches to stock picking. Most of these are not consistent or coherent. There is no clear, simple overarching framework. These people combine elements of the above three frameworks, and often hope this will work. There approach is like alphabet soup, and often comes from listening too much to the mass media, or attending seminars put on by people who do not have a sound approach ,and who are more interested in ‘sales’.

For example if we combine a trend approach with a PVI approach we immediately run into a conflict. Trend investors will sell when they think the trend is ‘invalid’. PV investors will want to hold. What do we do when the charts conflict with the fundamentals?

Simplicity

The other important component is simplicity. A simple, coherent, rational framework works better over time. It is scalable. It has less moving parts, less gaps where doubt or psychological biases can creep in. Simplicity breeds discipline. Disciple breeds consistency. Consistency is the key for compounding and long term success.

Which?

Which framework should you adopt? This is a matter for you because objectives, psychologies and circumstances may vary. However, before deciding fit, you must be satisfied the approach works. Is there long term evidence your chosen approach can consistently beat the index? If not, then you might be better off simply buying a broad based index fund, such as the Australian ASX S&P200 or the US SP500, through say an Exchange Traded Fund (ETF).   

Here it is worth remembering, that there is significant evidence now, most fund managers cannot consistently beat the index over the long term. Long term is 20 plus years, because this is usually our investment horizon. Beating the index over 5 years or even 10 years and not more, may seem good, buy it falls foul of the Recency Bias. This is a psychological bias we all have- we believe recent data proves future data. The better approach is long term historical data to give us a sound probability of similar future long term data.

Warren Buffett is the only investor who has a coherent, rational framework and who publishes his 20 year plus results through Berkshire every year. You can easily download his annual letter at Berkshire Hathaway: http://www.berkshirehathaway.com/letters/letters.html . At the very onset you can see his long term results, looking at the market value of Berkshire 1965 to 2018, Buffett has achieved an average of 20.5%, beating the S&P500 which has an average of 9.7% during this 53 year period (Buffett, W. 2018, ‘Shareholder Letter 2018’, accessed 5 April 2019, < http://www.berkshirehathaway.com/letters/2018ltr.pdf >).

The question for us is clear. Do we have a coherent, simple framework that can achieve similar, consistent returns in the long term? If we are following the approach of someone else or using managed funds, what evidence do they have of consistently beating the index for at least 20 plus years?

Choose One

Whatever you do, it is important to go beyond your stock selection criteria, and find one overarching method or framework. Ask yourself, objectively does it work? Has it been proven to work? Not simply, ‘well I think it has worked’, or ‘I hope it has worked.’ What evidence is there for your chosen framework working for 20 plus years ? In addition, does it fit your objectives?

Investors in any asset class will usually have four key objectives-

  1. ROI. A good long term return on investment (over the index), commonly 7-11% ROI pa.
  2. Safety. A safe approach where permanent capital loss is unlikely.
  3. Yield. For older investors, they will be more interested in a strong yield, however other fundamentals of the business should not be ignored. ‘Pure Yield Plays’ are usually not sustainable.
  4. Personal Fit. The approach must personally and psychologically fit you. Too often, this is overlooked. Having a strong ‘sleep at night’ factor built into your approach is important when dealing with the uncertainties of the markets. It may also help you to see market corrections differently- for instance, as positive opportunities.

Deep Engagement

It is important to deeply engage with your chosen method. Research it, find its strengths, weaknesses and limits. Find the heroes who have refined and made it workable in the long term. Look beyond the ‘sales speak’ and find the substance. Find your fit. Moving from a haphazard or inconsistent approach to a disciplined and highly rational approach, will immediately put you on a journey towards mastery. Over the years, we too have found mastery is closely connected to simplicity and flow.

“Simplicity breeds discipline. Disciple breeds consistency. Consistency is the key for compounding and long term success.”


Regards, Lee M. Spano, Founder, Creatness International Founder www.creatness.com 

© Copyright Lee M. Spano. All rights reserved.