Apprenticed Investor has dealt with a lot of theory. We've discussed how emotions lead to bad decision making, and why you should stick to your plan. But I know what you really want: some advice on how to select stocks. That's our goal today.
The idea is not to pick stocks for you, but to help you develop a methodology for selecting stocks -- a set of tools, a checklist of sorts, to help determine whether a given stock is worthy of your attention.
One caveat: We are not addressing whether you should be a buyer of stocks
. Our discussion assumes your asset allocation is appropriate, and that the market is not in a high-risk, low-return territory. I'll address each of those concerns in a future column.
So without further ado, here's our favorite prepurchase checklist.
How's the Chart?
Charts are a great time saver, and for that reason it's where we begin. You don't have to be a technician to uncover potential problem stocks quickly and eliminate them from contention.
Glimpsing at a chart provides three ways to erase a stock from your list: One, if it's been in a long downtrend, avoid it all costs; two, if it's been flatlining for years; and, three, if it's too volatile for your risk tolerance.
Note, however, that eliminating a given stock doesn't mean forgetting about it. Take, for example, the stock in a downtrend. Since we don't know when the institutional money (i.e., mutual funds) will be done selling, it's simply wiser to wait for them to finish distributing. You can use a 10-day moving average to let you know when the downtrend may be ending.
The same thinking applies to a flat-liner. Instead of guessing what's going to make it finally break out, apply the same moving average to let yourself know when the stock is finally moving.
Meanwhile, stick to charts that don't have problems. (For more detail on how to use technical analysis, check out "Tracking Elephants," parts
How's the Sector?
Here's something few people are aware of: Academic studies show the sector a stock is in is actually more important to its performance than the company itself.
This suggests that even the best stock in a lousy sector will do poorly when that sector is out of favor. At the same time, any old company in a hot sector will do well.
For example, personal computers went nowhere after all of the Y2K upgrades were completed. Indeed, even
has been range-bound for the past three years. The same goes for the networking stocks -- what company is better than
On the other hand, you could have thrown a dart at oil companies such as
or homebuilders, including
, and they have been screamers in the past year.
Checking out the sector also gives you an idea of who the competitors are.
The same advice about individual charts also applies to sectors -- watch those sectors near the bottom of the
performance rankings for signs of an impending turnaround.
Only buy stocks in good sectors.
What's Your Thesis?
Why buy this particular stock, in this sector, and why now?
That may sound like an obvious question, but it's often overlooked. You should have a specific reason to buy something, one that you can articulate in a sentence or two. It can be something fundamental, i.e., fiber to the premises. Have you found an overlooked value, do you have some insight into a new product, do you believe the new management can turn the ship around? All that is part of your investment thesis.
Part of your opinion should include a price target. Let's assume your hypothesis is right -- when the rest of the Street discovers the stock, where can it go? I prefer to use two targets: a reasonable price and a best-case scenario. That way, I can revisit my thesis later and see if a stock that's working is worth sticking with.
The investment thesis should also consider upcoming catalysts, which you should track to both confirm your upbeat view, and to see how the stock reacts.
The ideal time to determine a stop-loss is before you buy it -- while you are neutral, and have no emotional investment in the name.
Stop-losses come in many flavors: percentage, trend break, support, moving average. (We will discuss this topic in agonizing detail in the future.)
Your thesis may be your primary motivation for selecting this stock, but it's also a reason to jettison it down the road. When your thesis no longer applies to a given company, it's time to say "buh-bye." Let's say you bought
because you so totally respect Ed Zander. If he resigns, guess what? Your purchase thesis has just become inoperative.
Your time horizon is another type of stop-loss. Not only should you determine how much you are willing to give up on any investment, but also how long you are willing to forgo other investments by locking up cash in this name.
This is another overlooked aspect of a stock selection. How much potential upside can you legitimately expect vs. your downside risk?
The reason this matters is that all stock-pickers are imperfect. Nobody should expect to be right every time. Indeed, if you are right half the time, consider yourself above average. That's why risk/reward is so important. The investor who bats .500 must not only offset his losses but also his commissions on all trades, and his taxes on the winners.
I find a 5-to-1 risk-reward ratio is ideal, meaning I can reasonably envision $5 of gains for every $1 of potential downside, but at a minimum, you want a 3-to-1 ratio. That way, even a .500 batter comes out ahead. Use your upside target and your stop-loss to calculate this ratio.
News and Earnings
Lastly, potential purchasers must familiarize themselves with all of the recent news on the stock, if for no other reason than to avoid an unpleasant surprise. Trust me, that's no fun.
Learn if there are any significant upcoming dates that could affect your holding. I've seen unaware investors buy stocks the day before earnings, only to have a weak report crush the stock price (ouch). Are there any upcoming court decisions, or a new-product introduction on the horizon? Pay particular attention to litigation, government investigations or regulatory agencies.
These items are not usually fatal, but they introduce another element into the mix. Indeed, sometimes it even creates opportunity. When
(then known as Philip Morris) was in class action litigation, the stock became a teenager. If you understood the litigation, and were willing to accept the risk, there was a lot of upside.
Finally, if you want this checklist to be of any value, I suggest you actually track every stock you buy or are considering buying. Save them all in a binder and then input the results to a spreadsheet such as Excel.
The goal is to create a data source that allows you to eventually be able to see where you are going right -- and what you might be doing wrong. It's an invaluable tool.
Notice that this list contains elements from the technical, fundamental and quantitative schools. When it comes to stock selection, I'm agnostic -- I use whatever tools contribute to the process. Just as you do not build a house with only a saw, there's no reason to ignore other tools, if they have value.
At the time of publication, Ritholtz was long BP and ConocoPhillips, although holdings can change at any time.
Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of Burst.com, a streaming media software company. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback;
to send him an email.