Turn on CNBC or Bloomberg at any point during the day and you’re bound to hear ten different stock-picking strategies within an hour. Investors love the idea of jumping into an investment and the potential to get rich on the idea.
Most of the hot stocks and strategies end up losing money…at least for the investors while brokers get rich on trading fees.
But there are three stock-picking strategies that have stood the test of time.
This is the seventh in our 20-part series reviewing each chapter of The Intelligent Investor, a book Warren Buffett called, “the best book on investing ever written.” Originally published in the early 50s by Benjamin Graham, the book has been updated numerous times and is a bible for the modern investor.
I am using the 2003 edition with commentary by Jason Zweig. We’ve been detailing each chapter and showing how investors can apply the advice to meet their investing goals.
Start here with our Chapter One review of Hot Stocks and the Intelligent Investor
I really enjoyed chapter 7, Portfolio Policy for the Enterprising Investor. Rather than what not to do, as was the case in the last chapter, Graham focuses more on what investors can do to find the best investments.
He starts the chapter with two of the most popular stock-picking strategies and shows why they just don’t work in real life. From there he outlines three investing strategies that actually have a chance at providing higher returns.
I’ve added my own commentary to each strategy and add one more ‘secret’ to successful stock investing strategies at the end of the review.
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Two Stock-Picking Strategies that Don’t Work
Graham starts off the chapter by looking at two popular stock-picking strategies that everyone loves but just don’t work. The problem for each leads to his two rules on investing strategies and three ideas that can actually produce higher returns.
Buy low, sell high and market timing strategies
The next chapter is dedicated to a more detailed look at market timing so Graham doesn’t go too far into it here except to provide some evidence that against the idea. The stock-picking rule to ‘buy low and sell high’ is so vague that it would be amusing if it didn’t lose so much money for investors.
It sounds easy enough and you would think there would be some way to decide whether stocks were expensive. We certainly have more than enough measures of value.
The price-to-earnings ratio is the most widely used. It is just the price of the stock divided by the amount of earnings (net income) over the last year or other period. Most investors look at the trailing four quarters earnings though it’s better to look at the average annual earnings over the past several years to smooth out any temporary changes.
That the P/E ratio would give you an idea on value and how expensive a stock may be is intuitive. Earnings belong to the owners (investors) of the company so the P/E is how much they are willing to pay for those proceeds. If the current P/E of a stock or the market as a whole is higher than past averages…then the investments are expensive, right?
The problem with the P/E ratio is that the average has changed dramatically over the past 20 years. I’ve used data from Robert Shiller’s cyclically-adjusted data to make the chart below.
You can see that by historical standards, the current P/E of 26 times earnings seems terrifically expensive. It would suggest that stocks are 33% more expensive than the average since 1966 and even more so if you look further back.
I’ll admit that I’ve pulled back on stock investments, holding more in cash and covering with options, over the past year. The bull market has more than doubled prices since 2009 and won’t last forever.
But if you were going by the 50-year average P/E ratio, you would have thought stocks were expensive for almost the entirety of the last two decades. You would have barely been investing any money in 2008 when you started taking money back out in 2009.
I start to get nervous when stocks approach prices 25-times earnings but the fact is that there is just no clear signal for when the market is too expensive or really cheap. Like most market timing strategies, you end up getting out too early and miss much of the rebound before investing your money back into the market.
Other investors have tried to use some kind of a percentage signal for market timing. The start pulling money out when the market passes a percentage, say 100%, above its cyclical low and start putting money back in when the market drops 10% or 20%.
I like investing more money in stocks when the market starts tumbling and will watch for 10% and 20% corrections if I have cash to invest. It never hurts to get a 20% discount even if you have to wait a while for prices to come back up.
The problem is with this stock-picking strategy is that there is no good percentage signal for when to get out of the stock market ahead of a crash. The graphic below from Mackenzie Investments shows the percentage up or down in the market for each cycle back to 1956.
The average bull market until the 80s only increased 83% before getting eaten by the bear. If you had used this percentage to get out of the market since then, you would have missed out on a huge amount of upside.
The average bull market has lasted 51 months over the 60-year period. Using this to get out of the market would have meant selling stocks in June 2013 and missing out on another 42% gain in the S&P 500 including dividends.
Someone is always touting their fool-proof market timing strategy and market anomalies to beat the market, so much so that few are ever held accountable when the strategy is proven wrong. There aren’t even signals that get you close to in and out at the right times. Market timing is a bust.
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Investing in Growth Stocks
Everyone wants to own the next Tesla Motors (Nasdaq: TSLA). Shares of Elon Musk’s electric car company surged more than 800% in just two years to September 2014.
Don’t like electric cars? How about a 1,400% return on shares of Netflix (Nasdaq: NFLX) in three years to September 2015 or a 7,600% return on Yahoo (Nasdaq: YHOO) in the three years to the new millennium?
Enter growth stocks as a stock-picking strategy!
The idea behind growth stocks investing is to invest in companies that are growing their earnings by very high percentages each year. All three of the examples above were transforming their industries during those early years and everyone expected profits to boom for years to come.
But that’s the problem with growth stocks. Investors get so excited about super-strong earnings growth that they ASSume it will continue indefinitely.
I highlighted growth stocks as one of the three worst stock ideas for your money a few months ago.
Investors pile into growth stocks on the assumption of never-ending growth that the price reaches ridiculous levels.
As I write this, investors are paying approximately 18-times the earnings expected over the next year for the general stock market. For shares of Tesla Motors, they are paying 223-times next year’s expected earnings!
All industries and companies see their earnings growth slow over time. Even disruptors like Tesla will eventually trade around the market P/E multiple. It will take years of super-stellar growth for Tesla earnings to catch up and justify the current price…and that’s assuming that earnings meet the lofty expectations.
Salivating over the meteoric return on Tesla stock to September 2014? Since then it has fallen 30% against a 10% increase in the S&P 500…all because that growth story is starting to break down.
Tesla is running into one of the biggest hurdles for growth stocks. It’s a victim of its own success. The company saw sales surge 387% to $2.0 billion in 2013. That kind of growth is possible from a low base of $413 million but the challenge is something else entirely when you consider sales of $4.0 billion last year.
The fact is that growth stocks as a stock-picking strategy are too well known by investors. Prices usually reflect the assumption of super-high future growth. If the company can meet those expectations, you’ve broke even at best.
Three Stock Market Strategies that Work
Graham does highlight three investing strategies that seem to work, if not some of the time. He outlines two criteria for why these stock-picking strategies work and what you need to look for in any strategy.
The investing strategy must meet a rational test. There should be some fundamental reason for why the investment will succeed. This is usually in some form of analysis of the company and its business.The investing strategy must be different and not overly used by the rest of the market. If everyone else piles into the same stocks, the price will be bid up and eat away at any potential profit.
Stock Strategies for Large, Unpopular Companies as the Contrarian
Investors love to hype stocks and rush optimistically in to the next hot names. The fact that the average bull market sends stocks 157% higher while the average bear market only takes 27% off prices should give you an idea of this.
Even in the worst economic times, it rarely takes investors long to jump back in and send stock prices higher.
So if we are looking for stock-picking strategies that are different from the general market’s then playing the contrarian should fit the bill nicely.
A contrarian investor is one that invests against the market consensus. If the market is unanimously optimistic, the contrarian starts selling stocks or covers with options hedging. If the market turns against a particular company, the contrarian takes another look and might invest.
Any of Graham’s three stock-picking strategies is going to involve work researching stocks and the contrarian play is no different. You can’t just rush in to invest in every company that sees its stock price fall. You need to analyze why investors now seem to hate the company and whether it’s temporary pain or a long road lower.
Graham suggests sticking with large companies for the strategy and I agree. The best example here is Warren Buffett’s investment in International Business Machines (NYSE: IBM). Buffett first started buying shares of the computer hardware company in 2011 and has since bought more for an investment topping $13 billion.
The Oracle of Omaha has played the contrarian for much of that time. Shares fell 42% from the 2013 peak to the beginning of this year as the company struggled to reinvent itself as a tech services provider. Sales fell 23% over the four years through 2015 to $81.7 billion, that’s $25 billion lower than 2011 revenue.
Few small companies would be able to survive that kind of a drop in revenue. While there are still large companies that go bankrupt, investing in those with a market capitalization of $10 billion or more means they will more likely have the financial power to survive and eventually turn to higher profits.
Graham doesn’t offer any clear signals for when to start looking at a stock as a contrarian investment. He talks about following the price-earnings ratio but doesn’t go into specifics.
The investing website Morningstar provides some helpful information on the current P/E and five-year average P/E of each stock for comparison. Go to a stock listing and click the ‘Valuation’ tab for comparisons on different valuation measures.
There is a warning here when it comes to playing contrarian as a stock-picking strategy. Some of the largest and strongest companies have made fools of investors. BlackBerry Limited (Nasdaq: BBRY), formerly Research in Motion, once ruled as the undisputed leader in mobile phones.
Shares reached an adjusted $138 each in 2008 before starting a painful descent as Apple chipped away at its market control. Contrarian investors were there all the way saying Blackberry could reinvent itself. More than eight years later, the stock is down 94% and is unlikely to ever regain much of that loss.
If you are going to play contrarian, follow these two rules:
Have a good reason for investing in the company through analysis of the business and its outlook.Don’t chase a stock too far, investing more 5% of your total wealth in any one company. If it does keep going lower, it won’t destroy your entire portfolio. Start out investing no more than a percent or two of your portfolio value and then invest a little more if the price falls further but at that 5% limit.
Bargain Issue Stock Investing
Graham’s next stock-picking strategy is to look for ‘bargain’ stocks. These are stocks trading at prices well under some measure of fair value.
He is again light on details but does talk about using two ways to find a company’s true value.
Fundamental analysis – This is the backbone of the investing community, looking at the potential for sales and earnings at a company to arrive at a value. Most investors are going to find it extremely difficult to spend the kind of time necessary to do that level of research but looking to analyst reports can help speed up the process.M&A analysis – What have other companies paid for similar companies in acquisition deals? This method is a little faster but you still have to estimate sales for the company and research deals in the market.
Graham doesn’t give much detail on the point at which you should consider a company a great deal. He says it’s hard to go wrong buying something for a 50% discount to its fair value but not much beyond that idea.
He does point out a good signal though it’s extremely rare. When a company’s stock trades for less than its current assets minus liabilities.
Current assets includes balance sheet cash, inventory of products and sales that have been booked but not collected from buyers. It represents fairly liquid assets that the company owns.Liabilities is the sum of the company’s debts and other obligations it must pay.
If a company’s market capitalization, the total value of shares, is less than current assets minus liabilities it means investors are getting all the plant, property and equipment essentially for free. You can buy all the future value of the company, everything it can generate from those long-term assets for nothing.
This signal is a good check on potential investments but I haven’t yet found a screener tool that looks for it specifically.
Special Situations Stock Investing Strategies
Graham’s final stock-picking strategy is to look for ‘special situations’ including:
Companies that might be good acquisition targetsBonds of bankrupting companies to get the restructured sharesMonopoly breakups like those in utilities and telecomCompanies hit with lawsuits
There are armies of analysts that focus specifically on one of these four stock-picking strategies. All four can help you finds some great investments but there is a lot of research involved.
For acquisition targets, you need to be able to see the fit between two companies and whether a deal can even happen against the potential for regulatory oversight. Often when one deal is announced, all the stocks in the industry will move higher on the idea that it will start a trend in M&A activity.
I would avoid bonds of bankrupting companies. This is a whole different universe of investing. You run the risk that the company isn’t able to restructure and pays little or nothing to bondholders.
Monopoly breakups are rare these days as most sectors have been privatized and deregulated. You could look for companies spinning off different segments into new shares but this means researching the benefit to each side being able to focus on one specific part of the business.
Investing in companies after the stock has fallen due to an announced lawsuit is probably the easiest stock-picking strategy but by no means easy if you do it right. Rather than just jump in to every lawsuit target, you have to have a good reason to believe that the lawsuit is without merit or that the market has overestimated the consequences.
These three successful stock-picking strategies should strike you as having one very important theme in common. All three involve some level of research. It’s Graham’s basic definition of an Enterprising Investor, the investor that is willing to do the research necessary to uncover good companies that can produce higher returns.
Reading through the book, every investor needs to take an honest look at themselves and how much time they are willing to commit to investing research. There is nothing wrong with wanting to sit back and watch your money grow without having to put any time into it…in fact, that’s going to include the vast majority of investors. If this is the case, be content as a defensive investor that enjoys the market return. Don’t worry about stock-picking strategies and ‘beating the market.’
If you do want a little higher return and are willing to spend the extra time researching your stocks, I would add one more criteria beyond Graham’s.
Stock Picking Strategies on Fundamental Analysis
There are really two types of stock picking strategies, those based on fundamental analysis and those based on technicals.
Fundamental analysis is the statistics in a company’s financial statements and its stock valuationTechnical analysis is based on the movement of the stock price
I prefer fundamental analysis because it makes more intuitive sense, you should be able to find good investments by comparing stocks on their profitability and other factors.
A few common stock picking strategies based on fundamental analysis include:
Valuation strategies use a stock’s price against a number of measures from earnings to sales and cash flow. The idea is that paying less per each dollar of earnings is a better deal. Valuation is important but understand that there are ways for companies to cheat on these numbers, artificially raising their earnings with accounting tricks.Growth at a Reasonable Price (GARP) is a favorite investing strategy for many because it combines both growth and value. Investors want a stock that is growing earnings quickly…but they don’t want to pay for it.Low debt and profitable is one of my favorite strategies based on fundamental analysis and not nearly as common as the others. The idea is to look for profitable companies, those with high operating margins, but with lower debt-to-equity than competitors. If they can create profits this way, an opportunity may exist to take on more debt and boost earnings.
Stock Picking Strategies on Technical Analysis
I’m not a fan of technical analysis but there are thousands of investors that do well on it. The problem is that computer programs and institutional traders can buy or sell on technical signals much faster and more efficiently than regular investors. This gives them an advantage in picking stocks based on these signals and puts you at a disadvantage.
Momentum signals follow a stock’s price higher. The idea is that investor sentiment tends to carry a stock in one direction, allowing momentum investors to profit for a time.
Volume signals focus on investor conviction in the movement of a stock’s price by comparing volume traded over a period against its average.
The Secret to Successful Stock-Picking Strategies
I like Graham’s two rules for stock-picking strategies, that the idea be based on a rational reason and that it be out of the ordinary.
But I’d also add the investor trait of patience to the list of requirements.
Even on the most detailed research and the highest level of confidence that a stock is a good investment, you may have to wait years for the price to prove you right. Getting frustrated that the market doesn’t see it your way risks selling out of an investment before the eventual turnaround.
If you are going to be investing in one of the three stock-picking strategies, spend enough time to build a strong conviction in the investment. Invest only a small percentage in each stock and hold it until your opinion plays out.
So I’ve managed to write another review that ends up being longer than the chapter itself. I promise I’m not trying to torment you. While The Intelligent Investor is a great book, sometimes I think it lacks the detail that real investors need to apply the teachings. I’ve tried to add that detail here in the reviews. I hope it is helpful.
I’ve used the three stock-picking strategies above and have worked for investment firms as an analyst using the three methods. I like the contrarian strategy the best, maybe it’s just my disposition to play devil’s advocate.
Check out each investing strategy and pick one on which to focus. Investing actively along just one theme and in just a few sectors will help you become an expert and reduce the amount of research you need to do. Do this with a portion of your portfolio, say 25% of your stocks, and leave the rest to passive investing in indexes and funds.
Don’t Miss these Other Posts in the Stock Picking Series