Stock picking: the art and the science

I was asked twice over the latter part of 2009 to pick a stock that I expected to perform well over the next 12 months.  This is always something of a challenge since the focus here is squarely on absolute return, the potential universe from which to select is immense, and you are up against an array of non-traditional investments that are inevitably picked by other folk, including anything from ultra-short exchange traded funds and obscure penny shares to exotic swaptions, writes Gareth Pulman, senior portfolio manager, RBC Wealth Management.
 
Because of my background and training, I tend to focus much more on identifying anomalies and opportunities in what I would describe as the traditional equity space with a strong conviction that market information remains imperfect and opportunities still exist to generate excess returns, particularly in the still-volatile markets we continue to see.  When one observes that a stock like Google Inc is up 120% from its January 2009 low at the time of writing, it seems pretty clear that opportunities to make money from stock picking within the traditional equity space were considerable around the market lows of 2009 – I believe that this remains the case today, although a good deal more selectivity is required.
 
Once the available asset universe is established (in this case equities trading on recognised stock exchanges), the question then becomes: how does one go about selecting a market-beating stock (and indeed, in the case of a stock picking competition, one that can beat all other recommendations made at the time)?  This is where what I termed in the title of this article “the art and the science” come into play.  Effectively, what stock picking really boils down to is identifying market mispricing.  Fortunately, we have largely moved beyond the days when companies released information selectively to favoured analysts or investors, allowing a select band of individuals to profit from market-moving news.  Likewise, the rise in influence of the internet has made it possible for even the smallest investor to obtain corporate releases practically in real time.  Of course, access to information does not mean that it can be used effectively.  The argument runs that in a market with imperfect information, investors will often times misjudge the impact of a piece of news flow on a stock and will not react appropriately. 
 
This would seem to suggest that the “artful” approach of making a snap judgment on a stock based on a particular piece of news may not be the most rewarding.  While it may work well for experienced short-term directional traders with a good feel for the market, most investors with a longer time horizon will probably be best served by more in-depth analysis of a company’s potential.  That is not to say that news surrounding a company should not be a factor in the investment decision – but it should likely not be the only or the deciding factor. 
 
Take the case of Google, mentioned earlier in this article.  No one particular piece of news can be said to have contributed to the inexorable rise in its share price since early 2009.  Instead, a consensus appeared to develop among investors around the notion that the stock was cheap relative to its own earnings outlook and growth potential.  This was accompanied by an overall improvement in market conditions, an expectation that the economy was improving (crucial for cyclical stocks, even those in a secular growth environment) and continued product innovation from the company.   It would have been hard in early 2009 to have made a solid investment case for buying Google based on any one single piece of information, but by combining all the relevant information an investor could likely have built quite a compelling case.
 
This seems to suggest that the best approach to stock picking is perhaps through a disciplined process of screening from the available universe.  I am not by any means advocating that a pure quantitative approach should be taken to stock selection (although this does have its place within the investment framework).  Instead, I would suggest that stock screening could perhaps be used as a starting point in identifying attractive stocks and in constructing an equity portfolio.   As I indicated earlier, the first step in this process should be to identify the investible universe that you are interested in.  This could be a particular region or sector, with universe constituents drawn from an index.  For example, a U.S. investor might look at the constituents of the S&P 500 Index as a starting point.
 
Beyond this, the screening process would most likely involve overlaying some sort of valuation framework on the stock universe.  The chosen screen very much depends upon your investment philosophy.  For example, a growth investor might choose to look at forward earnings growth, while a value or income investor might focus upon a company’s price-to-earnings ratio or dividend yield.  Many investors might find the best rewards over the cycle could lie in a combination of the two – something best described as Growth At a Reasonable Price investing.  In terms of screening, this would likely involve identifying those companies trading on a P/E multiple below the long-term average for the index, while offering above average earnings growth potential and a dividend yield above the average for the index. 
 
In the case of the S&P 500 Index, screening for companies with a Price-to-Earnings multiple below 16.6 times (the average for the index from 1968 to the present), a dividend yield above 2.05 per cent (the current average for the index) and 12 month forward estimated earnings growth above the index average results in a shortlist of 14 stocks from an original starting universe of 500.  Clearly this presents a much more manageable list from which to select possible investment opportunities.  This is the point where I would suggest the “art” should come into play.  Having narrowed down the available universe to 14 stocks, this would be a good time to look at news flow around the potential candidates, along with analysts’ investment reports and other relevant information.  This might also be an appropriate time to apply a thematic overlay to the process.  For example, you might be interested in GARP-type stocks but also believe that the insurance sector looks particularly attractive from an investment standpoint.  Based on the screen results, this would narrow down your list of possible investments to only two candidates.
 
I hope that I have given some flavour of a possible approach to narrowing down a myriad of investment choices into something more manageable.  While many of the tools required to do this are now available even to small individual investors, I would still counsel on the wisdom of hiring an investment expert to either assist with implementation or indeed to manage the assets on a discretionary basis.  In any event, it goes without saying that before reaching a final decision, it is always sensible to discuss your thoughts with a professional advisor.  I would also certainly advocate that the stock picking approach outlined in this article should generally be considered in the context of a well-diversified investment portfolio.

The views expressed are the opinions of the writer and may differ from the views of Royal Bank of Canada

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