How Do I Pick A Stock?

Transcription

1 How Do I Pick A Stock? Keep it Simple An investor wrote me an a few days ago, asking me a very simple question. She wanted to know how I pick stocks for portfolios that I manage. I often find inspiration for my Thought for the Week from discussions with investors and colleagues, so I felt compelled to share our conversation on the off chance that others out there share the same curiosity. My short answer to her was that I utilize a blended approach of both top down and bottom up analysis to derive the asset allocation and subsequently select the appropriate investment vehicles for implementation in the portfolios managed. Make sense? Probably not, unless you ve managed money professionally at some point in your career. For most, that last paragraph is as confusing as when I listen to a doctor explaining a medical procedure (a highly irrational fear of needles prevented me from attending medical school so I know next to nothing about medicine). However, I strongly believe that most difficult and/or technical subjects are best explained by using analogies, so let s spend some time discussing why the process of buying a stock is practically identical to buying a house. Location, Location, Location The process of buying a home begins with an analysis of the various neighborhoods in a specific area. For example, let s say that I am tired of New York City winters and interested in moving to southwest Florida to escape the cold.

2 There are several cities from Naples up to Tampa, each with different characteristics. Some cities are growing due to factors such as favorable demographics, low taxes, or perhaps even a fledging restaurant scene. Others may be in decline due to increased crime or a major employer in the area going out of business. The point is that some cities will be attractive and others will not. Upon completing research into the best cities in the area, I decide that Sarasota is most attractive due to its recent growth, proximity to beaches, and other favorable factors. The next step is to dig a little deeper and analyze which neighborhoods are the best in the area. Several attributes determine the appeal of a neighborhood, including the quality of schools, safety, access to highways, nice restaurants, etc. Note that the analysis at this level is typically more qualitative, where many of the factors can t be quantified. For example, do we really use numerical scores to compare one school system against another? Probably not. Most likely we would just conclude that one neighborhood has access to better schools than another. This process of picking the right neighborhood is absolutely critical. In fact, the three most important rules of real estate are (1) location, (2) location, and (3) location because the neighborhood determines the majority of the value of a home. Believe it or not, the first step in picking a stock is nearly identical to the process of selecting attractive neighborhoods for a home. I begin by looking across the major investment regions across the world to assess which have the most attractive economies. Data such as GDP growth, unemployment, inflation, and monetary and fiscal policies of governments usually give me good insight into the direction of an economy. Once I determine which regions are attractive (think picking a city), I dig deeper and look for which sectors (think picking a neighborhood within a city) in an economy are most appealing. Perhaps it s automobiles in Germany or internet companies in the U.S. This step is by far the most important in the investment process because much like in real estate, the three most important rules in investment management are (1) asset allocation, (2) asset allocation, and (3) asset allocation. It s no coincidence that location is found within asset allocation, and the table below confirms this truism by breaking down the determinants of portfolio performance over an average 20-year period: Determinant Value Asset Allocation 93.3% Security Selection 4.6%

3 Market Timing 2.1% Source: Brinson, Hood and Beebower, "Determinants of Portfolio Performance" (1986, 1991) Buy the worst house in the best neighborhood, and there s a good chance you will make money over the long run because location is the biggest determinant of gains in real estate AND investment management. Let s stop here for a moment and summarize what s happened up to this point. Both scenarios utilized a top down approach to selecting the attractive neighborhoods for a house and sectors within various economies for a stock. Meaning, the process began at a high level and dug deeper to look for possible places to live and to invest, and concurrently filtered out those areas that did not meet the criteria for ownership. NOTE: Although it may seem obvious, it s important to keep in mind that decisions are always made on expectations of future conditions. I typically only buy stocks in a sector that I determined would improve or at least remain attractive, much like I would only buy a house if I thought the neighborhood would improve or remain attractive. Next Step: Bottom Up The top down approach got me to the neighborhoods of interest in Sarasota, but now I have to shift my strategy to a bottom up one in order to find houses that meet my criteria. This process is a more quantitative one because I screen specific metrics to find a house that fits my needs. For example, let s assume that I need a minimum of three bedrooms, two bathrooms, a pool, and built after 2012 (I m not all that handy around a house and don t want to do any home improvement projects). A real estate agent could simply search through all available homes in the neighborhoods that I deem attractive but also met these characteristics that are specific to a house in order to narrow down the list of potential options. When it comes to picking investments, the bottom up process is nearly identical. I screen for companies in the sectors where I have determined to be most attractive on metrics such as strong cash flow, manageable debt levels, good margins, increasing sales, and strong market share. Once I have a short-list of potential investments, I do what anyone would do when considering buying a house - conduct a thorough inspection. In a house, a buyer may look for signs of physical damage or issues that may develop over time into costly repairs. For a stock, I review the competition, assess management quality, and dig deep into the financials to ensure there are no risks

4 to the future profitability of the firm. Simply put, the bottom up approach is designed to narrow down the choices within neighborhood and sectors. But we aren t done quite yet. It All Comes Down to One Thing The last step of the home buying process can often be just as important as picking the right neighborhood, because as the saying goes, it all comes down to price. No matter how good a house may meet my needs, I won t buy the property if it is overvalued. Unfortunately, the hard part is determining the real value of a home since the listing price is often set by the seller at his/her discretion. Therefore, a common strategy is to compare a house for sale against other homes that have recently sold. Relative measures such as price-per-square-foot are commonplace to compare the house for sale against others in the neighborhood. If a house is selling for $200/sqft, but comparable homes in the area have been selling for $100/sqft, then the home may very well be overpriced. The same logic applies for picking stocks. Once I have derived a short list of stocks that meet my strict criteria for ownership, I then run a nearly identical process to determine if I am getting a good deal. There are many ways to compare one stock to another, but arguably the most popular measure is the price-to-earnings (P/E) ratio. The earnings of a company is similar to the square footage of a house because both are usually considered to be the most valuable trait of each investment. NOTE: Relative measures can be completely arbitrary, but some matter more than others. For example, a buyer could compare the price of two homes against the number of fireplaces in each house, but are there really people out there who value fireplaces more than square footage? Simply put, earnings and square feet are usually the most important attributes that buyers want, and therefore, they make ideal relative measures in most circumstances. Implications for Investors A few weeks ago, I was forced to take my car to an auto body shop. Knowing more about medicine than I do about cars, I sat there perplexed when the mechanic first presented me with the quote for the repairs. However, as he explained his plan to fix my car, I felt far more comfortable

5 knowing that a trained professional was at work. He didn t empower me with enough knowledge to do the repair on my own, because skill and experience take years to acquire, but all I needed from him was a high level explanation of his process to feel better about paying him. The same principle should apply when an investor hires a firm to manager their nest egg, and a key tenet to Global Financial Private Capital s investment process is providing transparency. It s one of the many ways that separates us from the traditional mutual fund model, and we feel that the more open we are to our investors, the better off everyone will be in the long run. The bottom line is that I don t expect anyone to read this Thought for the Week and immediately feel adequately prepared to go out there and use this methodology to start buying stocks, but hopefully the day-to-day operations of our dedicated investment team are a little clearer now. This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion of our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private Capital is an SEC Registered Investment Adviser.