Feb 24, 2024

How I Pick Stocks

Most investment advisors share a similar opinion on buying individual stocks: Don't do it, but if you do, keep it small and be careful. I’ve followed little of their advice, although I’m well aware of the dangers that come with owning stocks.

I bought my first stock when I was in college and my second one some years later. One worked out OK, the other a bust. Regardless, I never quit and for most of this century I've had up to a third of my equities in individual stocks. Here’s the method to my madness.

For my early years, I mostly drove blind, quickly learning that this isn’t easy. I was amazed at my confidence when making a buy and my humility when the stock didn’t perform well, which was common.

Then I learned about stock ratings. This gave me some justification for purchases. During the Great Recession crash of 2008, though, I learned that the ratings were mostly useless.

But I never gave up. My next stop was to read The Intelligent Investor by Benjamin Graham, the bible for value investing. I’ve since stayed close to his basic theory that you can do well buying stocks at less than their true value. And there are well-known fundamentals that can help determine a stock’s value.

One of my key insights regarding investing was to learn that people – including me – have too much confidence in their judgment, specifically with forecasting. And investing is largely about forecasting market returns. Instead of trying to forecast, like our forefathers, if the fish are biting for others, we tend to move into the same waters.

The data is overwhelming that even professional money managers tend to run in herds, although chasing returns mostly doesn’t work. For various well-documented reasons, the professionals lag the market indexes. As much as we may know that a low price to earnings (P/E) ratio is one of the best indicators of future performance, we're still convinced that a rising stock will rise forever, P/E be damned.

Another of my guiding principles for living but especially for buying stocks is Occam’s Razor, also known as The Law of Parsimony. It recommends finding explanations that have the smallest possible set of elements. For buying stocks, this means limiting the data that I use to some key indicators that are generally available.

In summary, I’ve come to believe that picking stocks requires keeping your natural human emotions removed from the process as much as possible, primarily by limiting decisions to mostly verifiable data. And second, I don’t overcomplicate the process. There is an overwhelming amount of financial data available for a stock. It is critical to limit what of it is used.

So why could stock picking be this easy? Because although the principle is easy, its execution is very difficult. For example, today I own none of the big meme stocks driving much of the market, such as Netflix, Tesla and Nvidia. This is hard to do because the fishing has been great in this pool. But by most measures, these stocks are wildly overpriced, regardless of how well these stocks have done recently.

My buying approach is to establish some quantifiable indicators that suggest a stock may be undervalued. Then, when considering a stock, score it on each of these items, add up the scores and buy the winning stocks. You can do it on a napkin. The idea is to quantify your beliefs and then use this analysis instead of your emotions.

For example, historically stocks have had a P/E ratio of around 15. The S&P 500 today has a P/E nearly twice this. So looking for stocks with a P/E under 15 is a great starting point for quantifying the value of a stock. It’s easy to find another 3-4 similar type indicators.

Note that in recent decades, average P/E has risen due to an emphasis on so-called 'growth' stocks, fast growing stocks that are expected to be worth much more in the near future, rather than stable companies that are growing at a slower pace with a more mature (and lower) P/E ratio.

While it's possible to make a lot of money picking a winning growth stock, you are essentially betting on whether and how well the company will succeed, something that depends on many factors that are far more difficult to quantify. Alternatively, ‘value’ investing is done with companies that have already succeeded but whose current price does not reflect that success.

These are my basic steps. First, I have various ways to identify stocks that I may be interested in buying, sometimes because I know their product but often by using a stock screener available at many brokerage firms. I also consider what other equities I already have, working to maintain a level of diversification, whether in market sectors, market capitalization or location (US vs foreign).

Then I rate any stock I am considering by each of the following four fundamental measures: dividends, valuation, debt and financial strength. I score each item 1 (poor) to 5 (excellent), average the scores and then only consider a high scoring stock. That’s it!

Here’s the details behind each of my factors, all items well-known in investing and easily available to any investor.

Dividends are a good measure of a mature and healthy income producing stock. For this measure, I may consider its dividend return, recent growth rate and payout ratio, with some consideration to the type of stock it is. For example, a stock may not even have a dividend, which could make sense for a fast growing company that needs to reinvest all of its cash.

For valuation, I mostly consider its P/E ratio and its cash equivalent, price to free cash flow. P/E and free cash flow should be under 15 and they should be somewhat consistent. The lower the P/E, the higher the score.

I score debt based on its debt-to-capital ratio. Low or zero debt is great. A figure over 100% is a warning flag. The rest is somewhere in-between. The logic is simple: It’s hard for a company with little debt to go bankrupt.

Financial strength is a measure of how well it handles its money. For this, I again consider debt but I also check its current ratio plus a variety of profit returns, including return on equity, gross margin and net margin. High margins and low debt is good. High debt and low margins is not good. The rest is in the middle.

Four measures, four scores, average them and if it’s anywhere near 4 or higher, it could be an underpriced stock that will eventually rise.

Once I’ve considered a stock as potentially underpriced, I do some internet searching to understand what the company does. This includes a look through its most recent 10-K report. One of the fundamentals of investing in anything – funds, bonds, stocks – is that you have some idea of what it is and why it may increase in value.

There are many other considerations that can be used in selecting stocks, including sentiment, inertia, technical analysis or analysts’ ratings. But in time, none has much predictive power to where the price of a stock is heading. The algorithms used to backtest ideas become exceedingly complex, and in the end, mostly gives us some excuse to fish with the rest, which is where our emotions want to go.

Does this work? If we trust the complicated reporting out of Quicken, yes. But I am quite confident that it weeds out the market noise and instead finds solid investments that continue to perform well. But picking a stock is half of the battle. The other is when to sell, which in general is when a stock is something you wouldn’t buy. That is, update its score.

So if like me you want to own some individual stocks, some variation on what I’ve described is a good place to start. The process is straightforward: Use some standard measures to quantify the value of a stock, ignore the endless extraneous data and keep it simple. Finally, monitor what’s happening to any stock you buy, whether often or annually, to help learn from what you’ve done.

Still, I don’t recommend that anyone own stocks unless they are willing to work at it and feel comfortable with hard decisions and volatile returns. Human emotion will buy what’s hot (high-priced) and sell when things don’t feel good (low-priced). This runs counter to what works in stocks which is just the opposite, buying low and selling high. But that’s our human make-up, and it’s hard to fight.

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