Opening the Books: How We Pick Stocks
Ever wonder how we pick our buy/sell recommendations?Us too. So we thought we'd use today to open the books and show you how we do it.
For the most part, we implement a top-down approach to investing.
Every company operates within a certain environment, so the first thing we try to do is understand a given company's industry/sector.
Know the climate.
Let's use the beleaguered airline industry as an example.
It's characterized by bloated pension/health care costs, cutthroat competition, and high energy prices.
Those sorts of ills cripple margins, eat into profits, and even bring industries under regulatory scrutiny.
If the milieu is ugly, the stock is probably ugly. This is why you avoid the financials when rates climb and elude export-heavy stocks when the dollar's high.
Stocks only move for three reasons: corporate profits, interest rates, or exogenous shocks. Exogenous shocks, as you can imagine, include everything from earthquakes to lawsuits to a CEO's unexpected death.
After we digest macrowave data like economic sentiment and industry mood, we dig into the micro-specifics.
Whether we're deciding if a company's debt to equity ratio is too high or we're basement fishing for unjustifiably depressed multiples, we try our best to make sense of a company's numbers.
Financial health, it goes without saying, is of paramount importance.
One caveat, however: It doesn't matter if a company is making money hand over fist today -- can the company make money tomorrow (recall that investors pay for future earnings)?
Warren Buffett called it economic moat: how does a firm protect itself and prevent intruders from breaking into the castle?
Without a competitive advantage, a firm is vulnerable to better mousetraps, pricing pressure, and a plethora of other differentiators and/or quality advantages.
Even better than a financially sound company is a financially sound company that's underappreciated and yet to land on Main Street's radar. When an analyst wakes up from his slumber and intiates coverage on your secret, you can surely expect other analysts to follow suit. That's called herd mentality.
These sort of stocks we call Seinfeld stocks, named after the hit comedy.
Seinfeld didn't "break out" until its 6th or 7th season -- however, the show had a loyal, niche following for its first 4 years.
Some of the biggest winners in the history of the stock market were Seinfeld stocks -- success stories that chugged along and then flew straight to the moon after the masses got word.
Ideally, you'd like to see these stocks gradually undergo institutional and insider accumulation.
When the elephant jumps into the pool, the splash is large -- pensions, banks, mutual funds -- they've got fat wallets, so pay attention to what they're buying.
Insiders know more about a company's condition than anyone else - they look at the books almost daily. While insiders sell stock for many reasons, they buy for just one: they think the stock is going higher. There's even an academic theory purporting that insiders know more than you do -- it's called information assymetry.
Lastly, stock charts. Dismissing a chart is like going on a road trip without a map. You may reach your destination safe and sound, but why take the risk? Charts give you a snapshot of a stock price's past price/volume action and can tell you in a matter of seconds whether or not that spike you saw this morning on CNBC is worth fretting about or just a minor blip.
In the end, as cliched as it sounds, we're looking for growth at a reasonable price -- and we'll do whatever it takes to find it, even if it means going to the bathroom with a stock chart in hand or carrying an annual report into the jacuzzi.
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