Let's face it: stock picking is tough. Amonst the roughly 30000 exchange-traded stocks from the G8 economies, "stock picking" means you essentially believe you have the capacity to choose stocks that will do better than a diversified basket of stocks.
Concentrated, value/momentum/growth portfolios vs. a diversified approach. There are some very good stock pickers out there. One of them, for example, is Donville Kent, that focuses on companies with low P/E and high Return on Equity over time.
source: http://www.donvillekent.com/
(I have no affiliation whatsoever with DKAM)
We'll go into the technicalities of stock evaluation and portfolio construction in another post. This is an introductory post so stick with me. Stock picking is generally a bottom-up exercize. Companies are analyzed based on their financials over time (balance sheet, income statement, cash flow statement), their competitive environment (searching for a "Moat", a sustainable competitive advantage), the discount or premium vs. estimated intrinsic value, etc.
Basically the process aims at identifying:
a) robust companies that have survived the ups and downs of the economy over time;
b) companies that have one or more sources of competitive advantage;
c) companies that are growing at a sustainable pace;
d) companies that are not overvalued too much.
e) a potential catalyst that can give our equity a boost.
We're looking for absolute strength in fundamentals, that will transfer over to our ROI.
My first thought, when confronted with the universe of stocks (as opposed to a handful of FX pairs that I was used to working with) was this: how can I possibly compete with the thousands of analysts and specialists that are covering sectors, industries, details? How can I possibly make an educated guess as to the value of a company, that differs and that is at the same time logical and relevant?
The first thought was to concentrate on a sector or industry group and specialize. But that felt like a limitation. Of some sort. That's when I found another interpretation of stock picking, which is quite openly discussed by Alpha Architect in their blog and in their book "Quantitative Value".
http://blog.alphaarchitect.com/
I have no affiliation whasoever with Alpha Architect
(although I have exchanged emails with them, and I would
suggest that anyone interested in stock picking should
get in touch as well, as they are quite open to discussing
methods, ideas, etc.)
Alpha Architect struck a chord with me, because they admit that stock picking is "tough". So what they do, instead, is look for a relative strength approach. Their Quantitative Value filter essentially ranks stocks based on a series of criteria, and then they pick the best 30 stocks or so, and invest with confidence. I am currently reading the book "quantitative value" and will issue some sort of review when I finish it.
What I'm finding out is that similarily to trading (i.e. Coin Flipping), there isn't one absolute way to pick stocks and be successful. There are many ways. So here's what I believe in, and what I am open to debate:
whatever the method, it must be highly systematic. I believe that goo managerial decisions, good intangibles, will translate into measurable quantities. I believe in a systematic, rule-based decision making. In my trading, I attempt to be as systematic as possible. I thought I was 80% systematic...but recent attempts to code the method seem to put me at the 50% level...
The reason I appeal to the systematic methods, is because they are measurable and it's easy to identify issues if/when they arise. So even if you're a discretional trader and/or investor, try to establish some clear steps that form a common denominator for your decision making. It really does help. Also, by playing with numbers as opposed to playing with discretional views or narratives, I can stay objective and not pretend to know something about the industry or company. It's too easy to get caught up with a good story, and miss the objective clues.
Proceeding with my studies, I was determined to identify the links between company fundamentals and the stock price. The questions I wanted to answer (without taking for granted other people's work) were:
1) are fundamentals more predictive than just pure price action and direction?
Stated in another way: are fundamentals superior to technicals, for identifying future performance?
2) if so, which fundamentals are closely correlated to the stock price?
3) does the market discount current and future company prospects well? Or
4) does the market make mistakes in evaluating current and future company prospects?
So allow me to show some studies of mine, that are open to debate. All following screenshots are from Metastock Xenith/Reuters Eikon.
a) It is my contention that a company's Reinvestment Rate and Cash Flow per share, on a Trailing 12 month basis, are highly correlated to the stock's performance.
b) it is also my contention that Earnings Per Share (TTM) are "somewhat" correlated to price but in a dirty way. This would give strength to the claims that state how "earnings are frequently dressed up, or manipulated, in order to satisfy market expectations as much as possible". Thus, they are not a great indicator.
c) Cost of Revenue (COGS) is just as predictive as the EPS excluding extraordinary items.
d) EV/EBIT tracks price action. So it's not predictive, it moves in tandem with price. After all, it's an evolution of P/E, and frequently used to identify when a stock is "cheap". I would agree with this, although "cheap" is something that would need to be better defined. I do not find any added value in observing EV/EBIT
e) Revenue, TTM or QoQ shows a high degree of correlation with stock prices. I find value here.
f) Dividend Yield. Essentially it becomes a mirror image of price action, so no added value for me.
...and I did many other iterations. My conclusions can be summarized as such:
1) Market participants initially care very little about the company's financials. They care first and foremost about revenue and net income. Basically "is the company making money or is it losing money?". It is my contention that if you are to trade stocks only, then a quick look at profitability is all you need, and then you can switch over to your charts.
2) Market participants are quite good at discounting current conditions and near-term company prospects. This also got me thinking. All the "value pundits" talk about market inefficiencies, psychological biases and errors, mispricings in price vs. value. And yet, my own observation of current fundamentals vs current price led me to conclude that the market actually is on the ball. So this led to another consideration (below).
3) If fundamentals are important in determining the relative competitiveness and strength of a company, then it's not the YoY or QoQ reported numbers that count. The market is quite good at pricing in current fundamentals and even anticipating them to a certain degree. All you need as a 200 and 50 SMA and you will always be pointed in the same direction as near-term fundamentals. What makes the difference is the Longer Term averages in key fundamentals.
It's impossible to find a stock at a 52 Week Low that's not losing money. All stocks decline for roughly the same internal reasons: temporary difficulties, making less money or actually losing money. What changes is the stocks past. A stock with strong (er) long term fundamentals is more likely to survive over time, recover from a rough patch, beat it's competitors, retain it's Moat.
So then...how can you find a "true discount"....how can you find a "value stock"? And more generally, how can you find a stock that can survive for the next 10 years? Here's what I have found:
companies know their stuff (generally speaking). They will not get into trouble on their own. In order to find solid dips to buy into, you need to wait for "externalities" to hit. What are externalities?
- broad market weakness (the indicies will affect all stocks)
- cyclical issues
- geopolitical issues
In the subsequent posts on equities, I'll dig deeper into my findings, and my approach to stock selection.
Feel free to comment and open the debate!
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